Tax Practice Series Analysis
¶7100 Foreign Taxation
	¶7130. U.S. Persons' Foreign Activities
¶7130. U.S. Persons' Foreign Activities
by
Michael Mulroney, Esq. 
Professor of Law
Director, Graduate Tax Program
Villanova University
Villanova, Pennsylvania
and
Joan Arnold, Esq.
Lecturer in Law
Villanova Law School
Villanova, Pennsylvania
———— OVERVIEW ————
U.S. persons (including resident aliens) are taxed on their worldwide income at graduated rates without regard to the source of their income. Because of that, the Code provides no separate regimes for taxing U.S. persons' income not effectively connected with the conduct of a U.S. trade or business, or from investments in U.S. real estate interests. The identification of persons as U.S. or foreign, the characterization of income and transactions, the rules for the source of income, the method of attributing deductions to that income, and the elements necessary for the determination of the foreign tax credit, described in earlier chapters, apply to U.S. persons.
The principles that govern the determination of items of income, expense, deduction and credit of U.S. persons who have business or investment activities abroad are essentially the same as for those who have only domestic investments or business operations. Those rules are modified in some instances to take into account the way that foreign income and transactions fit into the U.S. tax system. The modifications fall into three general categories, discussed in this chapter: rules that modify the regular U.S. tax treatment of transactions which have foreign components; those that encourage or discourage specific activities or transactions; and a set of guidelines that governs certain of the foreign currency aspects of international activities.
Thus the Code applies disincentives to discourage U.S. persons from using foreign corporate entities to defer or avoid U.S. tax on events which would ordinarily generate current tax. Another set of rules fosters tax deferral to encourage U.S. persons to undertake the export of U.S. goods and services.
In instances where one end of an income stream between a U.S. person and a related foreign person is outside the United States, to the extent that income is artificially loaded into the hands of the foreign person it may be temporarily or permanently placed beyond reach of U.S. tax. In that case, the IRS is given the power to ensure that the pricing mechanism for income from the goods, services or capital yields an arm's length result.
Somewhat similarly, transactions that would have no particular tax significance, or different tax significance, if carried on entirely within the United States may create issues that need special attention when one leg of the transaction is outside of this country. Thus, for example, where property is transferred by a U.S. taxpayer from the United States to a controlled but separate entity in a foreign country, the U.S. taxpayer may be required to recognize gain on the transfer or to include income from the asset in his income subject to U.S. tax, even though he would not be required to do so if the transaction were wholly domestic.
In several instances the Code seeks to discourage commercial activities deemed to be socially or morally undesirable, even though those activities may be an accepted (or indeed necessary) form of doing business in the host foreign country. For example, U.S. taxpayers who do business with or in foreign countries that conduct international boycotts are subject to extensive reporting requirements, and if they participate in boycott activities they lose certain tax benefits. In addition, illegal bribes, kickbacks or other similar payments to foreign government officials in the course of commercial transactions result in the loss of tax benefits.
Finally, the Code provides a partial set of rules that govern the treatment of gain or loss from certain dealings in foreign currency and the translation of foreign currency-denominated earnings to U.S. dollar equivalents.
Although the provisions described in this chapter apply primarily to U.S. persons, in some cases they may also be applicable to foreign persons.
———— EXPLANATION ————
¶7130.01
Taxation of Worldwide Income
U.S. persons, including resident aliens,1   are taxed on their worldwide income at graduated rates regardless of whether the income is U.S. or foreign source. Because of that, and unlike the U.S. income tax treatment of foreign persons, as a general rule no distinction is made between types of income from foreign or U.S. sources.2  Income derived from a foreign country is taxed by the United States without regard to whether it is earned income, income from a trade or business, or investment-based income.
1See the discussion in ¶7110, above, of the classification of taxpayers and their identification as U.S. or foreign.
2 The most important exception to that general statement occurs with respect to the foreign tax credit and its limitations.
The general rules for determining items of income, deduction, expense, and credit apply in computing a U.S. person's tax liability arising from his operations abroad. However, since those general rules are designed to work mainly in the context of U.S. taxpayers' domestic activities, in some instances their application in an international context can lead to undesired results. Therefore, in some instances the Code modifies them, sometimes to address a particular situation that arises in their application to foreign activities, and sometimes strictly on policy grounds to provide an advantage to a U.S. taxpayer, or to prevent tax avoidance that can arise when the regular rules are applied in the peculiar context of foreign transactions.
 Example (1)—U.S. Individual's Worldwide Income
U.S. Person is a citizen of, and resident in, the United States. He inherited real  property located in Foreign Country when his grandfather died. He currently leases it to local Foreign Country farmers and receives a portion of their profits as rent. He is not involved in the farm operations. U.S. Person also receives a monthly payment from a Foreign Country trust created under the will of his grandfather, which is deposited in an account in his name in that country. U.S. Person's gross income for U.S. tax purposes includes both items of income, unless the U.S.-Foreign Country income tax treaty provides a rule to the contrary. If U.S. Person was a citizen of Foreign Country but a U.S. resident alien, the result would be the same.  
 Example (2)—U.S. Corporation's Worldwide Income
U.S. Corporation manufactures consumer goods in Ireland through an unincorporated division located in Innisfree. The Irish division maintains its own records, funds itself through third-party borrowing from the Bank of Ireland, and operates under the name of Innisfree Manufacturing Company. All profits of the division are reinvested in its Irish operations. The income and expenses of the Irish business are fully included in the annual computation of U.S. Corporation's U.S. taxable income.
The Code's modifications of the regular rules generally applicable to domestic transactions take several forms and apply to the inclusion of items in gross income,3  limitations on certain deductions that arise in a foreign context,4   disincentives to tax avoidance through the use of foreign entities or devices,5  incentives for congressionally favored types of foreign investments and activities,6 and mechanisms for the elimination or limitation of international double taxation.7
3See §911, discussed below at ¶7130.02, which allows for the exclusion of earned income of nonresident U.S. citizens from their gross income.
4See §168(g)(1)(A), which provides a limitation on the method of depreciation for property used by a U.S. person outside the United States.
5See the discussion of Subpart F, below at ¶7130.04.B, §951 et seq., which subjects to current U.S. taxation income earned by U.S. shareholders through certain controlled foreign corporations.
6See the discussion of foreign sales corporations (FSCs), at ¶7130.05.A, below.
7See the discussion of the foreign tax credit in ¶7130.03 and of tax treaties in ¶7140, below.
In addition, even though U.S. persons are taxed on their worldwide income, the determination of that income is dependent on established concepts of tax timing, tax accounting, the taxable year, the characterization of taxable persons, and the Code rules for income realization and recognition. Because most taxable events and activities embraced by the U.S. tax system are domestic, its rules are geared mainly to cover them. Some transactions that would have no immediate tax significance, or different tax significance, if carried on entirely within the United States may give rise to different considerations when one end of the transaction is outside of the United States.
Thus, for example, where ownership of appreciated property is transferred by a U.S. taxpayer to a controlled but separate entity in a foreign country, the U.S. taxpayer may still control the asset indirectly through his ownership of the entity, but gain from the later disposition of the asset by the foreign entity (classified as a separate taxpayer) may be beyond the reach of the federal tax system unless a toll charge or tax is levied on the otherwise unrealized gain embedded in the outbound asset.8   Somewhat similarly, where one end of an income stream between a U.S. person and a related foreign person is outside of the United States, there is the distinct possibility that income will be deflected artificially to the foreign person and deductions will be directed to the U.S. person, with tax results beneficial to the U.S. person but not to the IRS. In that case, the IRS is permitted to scrutinize and adjust the income and expense elements of the pricing mechanism between the U.S. and foreign interests, by applying the equivalent of an arm's-length bargain to the transaction.9
8See §367(a), which generally makes inapplicable the Code's gain nonrecognition rules where a U.S. taxpayer transfers appreciated property abroad in the context of a corporate organization or reorganization, and §367(f), added by the Taxpayer Relief Act of 1997, effective August 5, 1997,  which states that, to the extent provided in regulations, if a U.S. person transfers property to a foreign corporation as paid-in surplus or as a contribution to capital in a transaction not otherwise described in §367 (e.g., a capital contribution by a non-shareholder), the transfer is treated as a sale of such property for fair market value.
9See §482, discussed at ¶3600, above.
As a result, when a U.S. person's activities include foreign income or transactions, while the starting point is the concept that he is taxed on his worldwide income measured by domestic tax concepts, a number of modifications to and special rules under the Code apply. They are discussed in the remainder of this chapter.
In addition to the Code's modifications to the general domestic tax concepts when a U.S. person's activities include foreign income or transactions, tax treaties may also vary the general domestic rules. For example, the IRS stated that compensation paid by the German government for property located in the former East Germany that was confiscated by the National Socialist Regime before and during World War II is exempt from U.S. tax under Article 19(1)(c) of the 1989 U.S.-Germany Income Tax Convention.10  For further discussion of treaties, see ¶7140, below.
10Notice 95-31, 1995-1 C.B.  307.
¶7130.02
Foreign Earned Income and Housing Cost Exclusions
¶7130.02.A. Overview
A U.S. citizen or resident alien who meets statutory tests for foreign presence or foreign residence can elect to exclude from his gross income amounts of earned income from foreign employment, not to exceed the  "exclusion amount" in any taxable year (e.g., $78,000 in 2001, $80,000 in 2002, etc., as described below). In addition, he can exclude from gross income a housing cost amount based on a statutory formula.11  The provision applies only to a qualifying individual. It is not available for foreign services income earned by corporations, partnerships, trusts or estates.
11Section 911.
To be eligible for the exclusions the individual must have a "tax home" in a foreign country and meet one of two tests.12   He must be a "bona fide resident" of a foreign country or countries for a period that includes an entire taxable year,13  or he must be "present" in a foreign country or countries for at least 330 full days during a consecutive 12-month period.14
12 Under §911(d)(3) the "tax home" requirement is grounded in §162(a)(2). It is discussed in ¶7110, above, and ¶7130.02.C, below.
13§911(d)(1)(A). 
14§911(d)(1)(B). The Code permits residence or presence to be interrupted without losing his qualification in the event of war or civil unrest in the foreign country of residence or presence. §911(d)(4).
A taxpayer who meets either test is permitted to exclude up to $70,000 of foreign earned income per year from his gross income, for taxable years beginning before 1998.  The exclusion amount increases from $70,000 to $80,000, in $2,000 increments each year, beginning with taxable years beginning in 1998 and is indexed for inflation beginning in 2008.15  In contrast to investment income, earned income is income from personal services actually rendered, including income from the sale of certain property that is produced by personal services. 16  However, if a taxpayer is engaged in a trade or business in which both personal services and capital are material income-producing factors, for purposes of the exclusion his earned income is a reasonable amount of compensation for his services not in excess of 30% of his share of the net profits of the business. 17
15§911(b)(2)(A), (D).
16See Tobey v. Comr., 60 T.C. 227 (1973), acq., 1979-1 C.B. 1 (Artist's sales of his paintings to art galleries produced earned income); Rev. Rul. 80-254, 1980-1 C.B. 222 (Author's royalties are earned income).
17§911(d)(2)(B). 
A qualified taxpayer can also separately elect to exclude or deduct from gross income all or a portion of a housing cost amount. The allowance is determined under a statutory formula based on the taxpayer's actual foreign housing costs to the extent they exceed 16% of a designated level of U.S. government employees' base salary.18
18§911(c)(1). Housing costs are identified in the statute. They do not include mortgage interest and property taxes, nor costs that are lavish or extravagant. §911(c)(2). If the taxpayer's employer does not provide him with a housing cost allowance, the taxpayer can claim an amount equal to the allowance housing cost allowance as a deduction from gross income. §911(c)(3). 
Although employees of the United States are not entitled to the regular foreign earned income exclusion,19  the Code provides special rules for civilian U.S. government employees for foreign areas allowances, cost-of-living allowances, and Peace Corps allowances.20
19§911(b)(1)(B)(ii). See Eren  v. Comr., 99-1 USTC ¶50,599 (4th Cir. 1999); Adair v. Comr., T.C. Memo 1995-493; In re Nadybol, No. 99-10726-dk (Bankr. D. Md. 10/16/00) (taxpayer cannot exclude income received from Army Recreation Machine Fund (ARMF) while living in Germany as foreign earned income because ARMF was agency of the United States for purposes of §911(b)).
20§912. For a more detailed description of the rules outlined here, see 918 T.M. U.S. Income Taxation of Citizens and Residents Abroad.
Even though income from U.S. government employment is not within the general earned income exclusion, residence or presence in a foreign country while employed by the U.S. government can be taken into account in meeting either the bona fide foreign residence or the foreign physical presence tests described below.21
21Regs. §1.911-2(e). 
Comment: As the following discussion suggests, a number of the ingredients necessary to qualify for the earned income benefit are time sensitive. As a result, a well advised taxpayer may have a fair measure of control over whether he qualifies for the benefit.
¶7130.02.B. Basic Qualifications
The exclusions are available to U.S. citizens and resident aliens who meet the Code tests for a foreign tax home and who have foreign earned income. Nonresident aliens are not eligible, except that a nonresident alien married to a U.S. citizen or resident becomes eligible for the exclusions if the alien elects to be treated as a U.S. resident.22   A foreign country for purposes of both the earned income and tax home tests is generally territory under the sovereignty of a government other than that of the United States, including the territorial waters of the foreign country (as determined under U.S. law) and its air space.23
22§6013(g). See the discussion of the §6013(g) election, and its other ramifications, above at ¶7110.
23Regs. §1.911-2(h). However, under §911(d)(8), a foreign country that is on the restricted travel list under the Trading with the Enemy Act or the International Emergency Economic Powers Act is generally not considered a foreign country for the presence and income tests. In Notice 2003-52, 2003-32 I.R.B. 296, the IRS announced that U.S. residents traveling to Iraq under the Office of Foreign Assets Control general or specific licenses would be eligible to claim the housing and income exclusions.
 Example (3)—No Foreign Sovereignty
U.S. Citizen captained a tugboat in the North Sea for several years. He lived aboard the vessel. Because he failed to establish that the North Sea was under the sovereignty of any foreign country he was not entitled to the income exclusion.24 
24See Palisance v. U.S., 433 F. Supp. 936 (E.D. La. 1977).
¶7130.02.C. Foreign Tax Home
To be able to elect the foreign earned income and housing cost benefits, an individual taxpayer must have his tax home in a foreign country and be either:
•  A U.S. citizen who has been a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire taxable year; or
•  A U.S. citizen or resident alien who, during any period of 12 consecutive months, is present for at least 330 days in a foreign country or countries.25
25§911(d)(1). A resident alien who is a citizen of a U.S. treaty partner can qualify under the bona fide residence test as a result of the nondiscrimination clause of the treaty. Rev. Rul. 91-58, 1991-2 C.B. 340.
Somewhat unsatisfactorily, the Code defines tax home by reference to the use of that term in the business expense deduction section of the Code.26   There, the term is used in the context of a deduction for expenses for transportation, meals and lodging incurred while travelling on business away from home (usually in a context other than foreign). As a result, the IRS tends to view a tax home more from the standpoint of a place of business rather than a place of residence or abode, although some courts have looked to see where the taxpayer resides.27
26Section 911(d)(3) cross references to §162(a)(2).
27See Rev. Rul. 75-432, 1975-2 C.B. 60 (place of business). Compare Coombs v. Comr., 608 F.2d 1269 (9th Cir. 1979) (abode).
The regulations that implement the foreign earned income exclusion create a set of alternative tests for a tax home. In the first instance, a tax home is located at the taxpayer's regular place of business. If he has more than one regular place of business, his tax home is at the principal one. But if he has no regular or principal place of business, his tax home is at his regular place of abode. On the other hand, an individual cannot have a tax home in a foreign country for any period during which his abode is in the United States, although temporary presence here does not signal an abode in the United States, and simply maintaining a dwelling in the United States is not alone determinative of a U.S. abode even if his family lives there.28
28Regs. §1.911-2(b).
In most cases, when a taxpayer lives and works abroad it is not difficult to determine that he has a foreign tax home. In some instances, the issue is not clear.
 Example (4)—Foreign Business but U.S. Tax Home
U.S. Citizen's only employment was for a company in Angola, where he worked as a technician in the employer's compound. He performed services nowhere else. Under his arrangement with his employer, he was on duty in Angola for a 6-week period followed by a 4-week period during which he was not required to be at the compound. He chose to use his off-duty periods to return to stay with his family in Florida. While there he did no work for his employer, or for anyone else. His tax home was not in a foreign country.29 
29See James v. Comr., 55 T.C.M. 1122 (1988). The court found the taxpayer retained more substantial ties with Florida than he did with Angola.  See also, Woodall v. U.S., No. 97-0690 (E. D. La. 6/5/98).
1. Bona Fide Resident Test
If a U.S. citizen has a foreign tax home, he can qualify for the benefits of the exclusions if he was a bona fide resident of one or more foreign countries for an uninterrupted period that includes an entire taxable year. Once a bona fide residence has been established for an uninterrupted period that includes an entire taxable year, the taxpayer qualifies as a bona fide resident from the date that residence was established until bona fide residence status ends. Accordingly, a taxpayer can be a bona fide resident for a part of taxable year.
 Example (5)—Part-year Bona Fide Residence
U.S. Citizen becomes a bona fide resident of England on March 1 of Year One, continues that status during all of year Two, and until September 15 of Year Three when he returns to the United States. His period of bona fide residence extends from March 1 of year One through September 14 of Year Three.30
30IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
The bona fide residence test is somewhat subjective in its application. Generally, a resident is a person who is not merely passing through as a transient or a sojourner with no intention as to the length and nature of his stay. If, however, he goes abroad with a purpose that requires an extended stay to accomplish, and as a result makes his home temporarily abroad, he is a foreign resident even if he has the intent eventually to return to the United States when the purpose for his foreign visit has been accomplished.31
31The description of resident in the text is drawn from Regs. §1.871-2(b), but to some extent in this context those regulations are of questionable value. (See also, Regs. §§1.871-1, -7, -9.) Regs. §1.911-2(c) says that for purposes of determining bona fide residence under §911, the principles of §871 and its regulations apply. The cited §871 regulations were promulgated when they controlled the identification of U.S. residence for an alien individual. In effect, however, they have been superseded for that purpose by the 1984 Act addition to the Code of §7701(b), which provides fairly objective tests for U.S. resident alien status. See the discussion of §7701(b) in ¶7110, above.
 Example (6)—Transient Status
U.S. Citizen took an indefinite job assignment in a foreign country. Upon his arrival he found that the available living conditions not to his liking, and he started to look for another job. He was not a bona fide resident of a foreign country.32 
32See Lambach v. Comr., 11 T.C.M. 330 (1952).
 Example (7)—Indefinite Term of Employment
U.S. Citizen was given an indefinite appointment to work in London as the managing director of foreign subsidiaries of a U.S. corporation. While there he made a number of trips to the United States to visit his family and on business. He was a bona fide resident of a foreign country. The nature of the job was such that it could not have been carried out in an short period of time.33 
33See Rose v. Comr., 16 T.C. 232 (1951) (acq.).
 Example (8)—No Fixed Abode
U.S. Citizen worked as a geologist in Colombia with the expectation that he would be there for an indefinite but extended period. Because of the nature of his work, he had no fixed abode there. He was a bona fide resident of Colombia.34 
34See Swenson v. Thomas, 164 F.2d 783 (5th Cir. 1947).
 Example (9)—Several Foreign Countries
U.S. Citizen was the foreign representative of a U.S. airline. Although his office was based in a single foreign city, he traveled from country to country on a regular basis to carry out his duties. He was a bona fide resident of a foreign country or countries.35 
35See Glackin v. U.S., 110 F. Supp. 372 (S.D. Ill. 1953).
a. Complete Taxable Year
The bona fide resident qualification test has the additional requirement that the bona fide foreign residence must span at least a complete taxable year.36   Once the taxpayer has established a bona fide foreign residence, he need not be present in a foreign country or countries for a full taxable year. Trips the United States on business or pleasure are permitted.37
36§911(d)(1)(A). Taxable year is used in its general Code context for this purpose. See §441(b), 7701(a)(23). 
37Regs. §1.911-2(c). However, in the context of establishing the underlying factor of bona fide residence, frequent visits to the United States might undercut the taxpayer's position. See Example (4), above.
 Example (10)—Taxable Year Rule Illustrated
U.S. Citizen, like virtually all individual taxpayers, had a taxable year that was a calendar year. He accepted employment in Australia, and arrived in that country to begin work on January 3 of Year One, because January 1 and 2 were legal holidays there. His contacts with the country were such that he qualified from the outset as a bona fide resident. He left his Australian employment and returned to the United States on December 29 of Year Two. He was not eligible for the earned income exclusion benefit in either Year One or Year Two because he was not present in Australia for an entire taxable year in either year.38 
38See Dawson v. Comr., 59 T.C. 264 (1972).
 Example (11)—Short Taxable Year
U.S. Citizen arrived in Argentina on January 1 and became a bona fide resident of that country on that date. His taxable year was the calendar year. He died there on June 25 of the same year. He met the requirement for an entire taxable year because his death terminated his taxable year.39 
39See §443(a)(2); Roodner Est v. Comr., 64 T.C. 680 (1975); contra, Witt Est. v. U.S., 1956-2 USTC ¶10002 (D. Ga. 1956)
 Example (12)—U.S. Vacations
U.S. Citizen established a bona fide residence in England. Thereafter, he returned to the United States regularly on vacation and to visit his family. His bona fide residence for an entire taxable year was not affected by those absences from England.40 
40See Rose v. Comr., 16 T.C. 232 (1951).
b. Exception
The Code provides a favorable exception to the taxable year test if the taxpayer is required to leave a foreign country of bona fide residence as a result of war, civil unrest or other similar conditions that preclude the normal conduct of business by the individual. 41  In addition, bona fide foreign residence is not impaired if the taxpayer is required to be absent from his bona fide foreign residence to satisfy U.S. military service obligations, and returns to his foreign residence at the conclusion of his service.42
41§911(d)(4). The IRS lists the foreign countries and time periods that apply for purposes of the exception in revenue procedure form. See, e.g., Rev. Proc. 2004-17, 2004-10 I.R.B. 562; Rev. Proc. 2003-26, 2003-13 I.R.B. 666; Rev. Proc. 2002-20, 2002-14 I.R.B. 732; Rev. Proc. 2001-27, 2001-19 I.R.B. 1155; Rev. Proc. 2000-14, 2000-18 I.R.B. 960; Rev. Proc. 99-20, 1999-14 I.R.B. 7;  Rev. Proc. 98-38, 1998-27 I.R.B. 29;  Rev. Proc. 97-51, 1997-2 C.B. 526; Rev. Proc. 96-33, 1996-1 C.B. 720.
42Rev. Rul. 70-374, 1970-2 C.B. 154.
There are some situations in which a taxpayer is effectively disqualified from proving a bona fide foreign residence. The Code bars a taxpayer from relying on the bona fide resident test (but not the foreign presence test, described below) to gain the earned income exclusions if (i) he has earned income from sources within a foreign country, (ii) submits a statement to the authorities of that country averring he is not a resident there, and (iii) is thereby not subject to income tax in that country as a resident.43  That disqualification is a one-sided coin, however. The fact that the foreign country treats the U.S. taxpayer as a nonresident, and he is required to file an income tax return there as a nonresident, does not necessarily negate his treatment as a bona fide foreign resident for U.S. tax purposes.44
43§911(d)(5).
44See Rev. Rul. 78-254, 1978-1 C.B. 243
 Example (13)—Disqualification by Declaration of Nonresidence
U.S. Citizen lives in Foreign Country and has earned income from services performed there. As a necessary condition of receiving a work permit, U.S. Citizen executed an affidavit that his status was that of nonresident under Foreign Country law. As a result, his income from sources in that country is not taxed to him as if he were a resident. For purposes of the Code's earned income exclusion he cannot claim that he is a bona fide resident of Foreign Country.45  The disqualification would not apply, however, if U.S. Citizen was deemed to be a nonresident of Foreign Country because of the application of a U.S.-Foreign Country income tax treaty, and he either did not file the affidavit described in this Example, or filed a statement of qualification for nonresident status under the treaty.46 
45Regs. §1.911-2(c). However, if U.S. citizen was a bona fide resident of a different foreign country, worked temporarily in Foreign Country, filed the affidavit described in the example, his earned income from Foreign Country (as well as other foreign earned income) would be eligible for the exclusion. See id.
46See Rev. Rul. 72-497, 1972-2 C.B. 448.
 Example (14)—Foreign Nonresident Tax Status
U.S. Citizen meets the Code requirements for bona fide residence in Belgium. Because of the circumstances of his employment, under Belgian law he is treated as a nonresident and files a Belgian income tax return consistent with that classification. The Code disqualification does not apply, he is treated as a bona fide resident of a foreign country for U.S. tax purposes, and his Belgian earned income is eligible for the exclusions.47 
47See Rev. Rul. 78-254, 1978-1 C.B. 243.
c. Break in Residence
When a bona fide foreign residence terminates depends on all of the facts and circumstances. In the usual case there is no difficulty in making that determination. The taxpayer simply packs his bags, ships his family and furniture, closes his foreign bank account, sells his car, and comes back to the United States. Given modern personal mobility, and changeable human circumstances, however, in some cases the point at which a bona fide foreign residence terminates may be less than cut and dried. In general, the tests appear to turn on the taxpayer's actual departure from his foreign country of residence, coupled with the absence of a specific intent to return to that or any other foreign country.48
48See Carpenter v. U.S., 495 F.2d 175 (5th Cir. 1974); White v. Comr., 22 T.C. 585 (1954).
 Example (15)—Two Foreign Duty Posts: Break in Residence
U.S. Citizen is employed by a multinational corporation as a career manager of foreign operations. He was a bona fide resident of England from October l of Year One through November 30 of Year Two. On December 1 of Year Two his employer instructed him to return to the United States to await another foreign assignment. U.S. Citizen and his family immediately returned to the United States with their household goods. In early December of Year Two he was informed that he would be assigned to the company's Paris office, and on December 26 he and his family arrived in Paris and immediately established a bona fide residence there. U.S. Citizen does not qualify for the earned income or housing cost exclusions for either year because he was not a fide foreign resident for entire taxable year.49 
49See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. Citizen may qualify under the foreign presence test, described below at ¶7130.02.C.2.
 Example (16)—Foreign Duty Posts: No Break in Residence
Assume the facts in Example 15, except that upon termination of his posting to England U.S. Citizen was immediately assigned to the Paris post and instructed to begin work there on December 26 of Year Two. He shipped his furniture to the Paris apartment provided by his employer, and he and his family returned to the United States to vacation from November 1 to December 26. He was a bona fide foreign resident of a foreign country for all of Year Two and thus can elect the exclusion benefits.50 
50Id.See Rev. Rul. 73-492, 1973-2 C.B. 291 (Employer returned taxpayer to the United States for training and reassignment to another foreign country).
2. Foreign Presence Test
If a U.S. citizen or resident alien has a foreign tax home he can qualify for the benefits of the exclusions if he meets a foreign physical presence test. He must be present in one or more foreign countries during at least 330 full days any given 12-month period.51  Those days need not be consecutive. And although the predicate for qualification is a foreign tax home, not all of the days need be business days or days spent doing business; some of the qualifying time can be vacation days spent in a foreign country.52
51§911(d)(1)(B).
52See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
Because the test is an objective one based on the number of days of foreign presence, it lends itself to proper manipulation by informed taxpayers. At the same time, however, because it is an objective test there is no leeway for exceptions (other than the waiver for civil unrest or war, described above 53   ) based on illness, vacations, or an employer's requirements. The factors described below are strictly applied.
53Section 911(d)(4), described above at ¶7130.02.C.1.b.)
a. 12-month period
The period of 12 consecutive months can begin on any day, and ends on the day before the corresponding day in the 12th consecutive month. Also, the 12-month period can start on, before, or after the taxpayer's arrival in a foreign country, it can end before or after his departure, and consecutive 12-month periods can overlap.54
54Regs. §1.911-2(d)(1).
 Example (17)—Choice of 12-Month Period
Resident Alien is a construction supervisor who works on and off in several foreign countries over a 20-month period. The first several and the last few months of that period are broken up by long visits to the United States for orientation and debriefing. Depending entirely on the day count, over the course of the 20 months Resident Alien may be able to put together 330 full days abroad during a consecutive 12-month period since that period can begin and end on any day.55 
55See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
 Example (18)—Overlapping Periods
U.S. Citizen works in Canada over a span of 20 months that begins on January 1 of year One and ends on August 31 of year Two. He spends the entire month of February in both years in the United States on vacation. By overlapping the available 12-month periods he can meet the foreign physical presence test for the entire 20 months. Thus, his first period of 12 consecutive months begins January 1 and ends December 31 of year One, and during that time he has 335 full days of foreign presence in Canada (365 minus 28 U.S. days minus two partial days for travel between the United States and Canada (assume January 31 and March 1), discussed below). His second period of 12 consecutive months begins September 1 of year One and ends on August 31 of year Two, and during that time he again has 335 full days of foreign presence in Canada (same assumptions). As a result, he can elect exclusion treatment in relation to his foreign earned income for the entire 20-month period.56 
56Id.
b. 330 Full Days Test
The taxpayer must spend 330 full days in a foreign country during the measuring period. The days need not be consecutive. A full day is a continuous period of 24 hours beginning with midnight and ending with the following midnight. In general, each qualifying full day must be spent within a foreign country. As a result, in traveling from the United States to a foreign country, or between foreign countries, time spent on or over international waters does not count.57 Time spent in traveling entirely over the territory of one or more foreign countries, however, is considered time spent in a foreign country.58
57Regs. §1.911-2(d)(2).
58Regs. §1.911-2(h).
 Example (19)—Same-Day Foreign Travel
At the start of his Canadian job, on December 31 the taxpayer in Example (18) drives from Alexandria, Virginia to Niagara Falls, New York, where he stays overnight in a motel. On January 1, he drives over the bridge to Niagara Falls, Ontario and reports for work at his employer's office in that city at 7 a.m. His first full day in Canada is January 2. If he had stayed in a Canadian motel the previous night he would have added an extra day to his tally.
 Example (20)—Foreign Nonterritorial Travel
Resident Alien leaves New York by plane for England on the evening of June 10 and arrives there at 9 a.m. on June 11. His first full foreign day is June 12. On another trip the following year, Resident Alien left New York on June 10, the plane crossed into English territorial waters east of Holyhead at 11:30 p.m. the same day, and landed at Heathrow Airport outside London at 12:30 a.m. on June 11. His first full day in a foreign country is June 11.59   Now assume U.S. Citizen leaves San Francisco by plane for Tokyo on June 10 and arrives there the next day, June 12 (because of having crossed the International Date Line). His first full foreign day is June 11, measured by reference to the date of his place of origin in the continental United States.60 
59 See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
60There is no published authority for this result. In the authors' experience, in different audits the IRS has taken the position most unfavorable to the taxpayer (depending on the direction of the taxpayer's travel across the International Date Line).
Travel from one place to another in a foreign country, or to another foreign country without being outside the territorial limits of a foreign country for more than 24 hours, counts as a full day in a foreign country. If any part of the travel is outside the territory of a foreign country for more than 24 hours, full days are lost. If the taxpayer travels between two foreign points with a layover in The United States for less than 24 hours, he is treated as being neither in the United States nor in a foreign country.61
61Regs. §1.911-2(d)(2).
 Example (21)—Foreign-to-Foreign Travel
U.S. Citizen travels by plane from Paris to San Juan de Compestella on the northeastern tip of Portugal. He leaves Paris at 11 p.m. on July 6 and arrives in Portugal at 3 a.m. on July 7. Both days count as days of foreign presence. If he flies from London to Compestella, he leaves London at 11 p.m. on July 6, on a flight path over the international waters of the Atlantic Ocean, and arrives at Compestella at 5 a.m. on July 7. Both days count as days of foreign presence. On a more leisurely trip, U.S. Citizen leaves Southhampton, England by ship at 10 p.m. on July 6 and arrives in Portugal at 6 a.m. on July 8. Because the sea trip involved being outside a foreign country for more than 24 hours, July 6, 7 and 8 are not days of foreign-country presence. If U.S. Citizen remains in Portugal, his first full day of foreign presence there is July 9.62 
62See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad; Regs. §1.911-2(d). The cited regulation contains a detailed example of the computation of the days of foreign physical presence.
Physical presence in a foreign country does not include presence on a foreign-flag vessel or foreign-owned drilling rig in nonterritorial waters.63   In addition, the IRS has ruled that presence on a fishing vessel operating within the continental shelf area of a foreign country over which the foreign country exercises taxing jurisdiction does not meet the foreign personal presence test.64
63See Bebb v. Comr., 36 T.C. 170 (1961). 
64Rev. Rul. 73-181, 1973-1 C.B. 347. The ruling depends on fairly tortuous reasoning, and is questionable from the standpoint of the policy of §911, particularly if the crew's wages are subject to tax by the foreign country. At apparent odds with the ruling, IRS Pub. 54 states: "The term "foreign country" includes the seabed and subsoil of those submarine areas adjacent to the territorial waters of a foreign country and over which the foreign country has exclusive rights under international law to explore and exploit the natural resources." (Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.) In any event, the ruling does not apply, and the fishermen would meet the foreign physical presence test, if the fishing occurs within the territorial waters of the foreign country as determined in accord with U.S. law. See Regs. §1.911-2(h).
¶7130.02.D. Excludable Foreign Earned Income
1. General Rules
In general, foreign earned income is income received for services performed by the individual in a foreign country during the period he is a qualified individual; that is, while he has a foreign tax home and meets either the bona fide foreign residence of the foreign physical presence tests.65   The amount that can be excluded is limited in any taxable year. 65.1  Rules, described below, are provided for the treatment of income received by the taxpayer in a year following the year in which the income was earned.
65§911(b)(1), (d)(2).
65.1For calendar years before 1998, the maximum exclusion was $70,000. For 1998, it is $72,000, increasing to $74,000 in 1999, $76,000 in 2000, $78,000 in 2001, and $80,000 in 2002. Starting in 2008, the $80,000 amount will be indexed for inflation. §911(b)(2).
Earned income is from sources within a foreign country if it is attributable to services performed by an individual in a foreign country. The place of receipt of the income is not material for this purpose.66   However, if earned income relates to services performed both within a foreign country and outside of a foreign country (e.g., in the United States or international waters), an apportionment is required. Normally apportionment is based on work days in a foreign country over total work days for which the earned income was paid.67
66Regs. §1.911-3(a). That is consistent with the general source rule for service income;  i.e., the source of the income is the place where the services  are performed. §861(a)(3), §862(a)(3).
67See Regs. §1.911-3(d).
 Example (22)—Apportionment of Earned Income
U.S. Citizen is a bona fide resident of Foreign Country who works there as a mining engineer. His normal work week is five days, and his annual salary is $36,800, all of which is earned income. He receives no fringe benefits or non-cash compensation. He spends six weeks working for his employer in the United States. After eliminating week end and vacation days, he has a total of 240 work days during the year. He can elect to exclude earned income $32,200 (210 foreign workdays over 240 total workdays times $36,800).68
68See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
Earned income generally includes wages, salaries, professional fees, commissions, bonuses, tips, and other amounts received by the taxpayer for personal services actually rendered by him. In addition, in the case of a taxpayer who operates an unincorporated business (for example as a proprietor or a partner) in which both personal services and capital are material income-producing factors, earned income includes a reasonable allowance as compensation for personal services not in excess of 30% of the taxpayer's share of the net profits of the business.69
69§911(d)(2); Regs. §1.911-3(b)(2). See generally TAM 9621002.
Earned income includes the fair market value of property or facilities provided by an employer, such as lodging, meals, an automobile, and other noncash fringe benefits. It also includes allowances or reimbursement for cost of living, overseas pay differentials, family expenses, education, home leave payments, quarters allowances, certain moving expense allowances or reimbursements, and similar items.70
70See Regs. §1.911-3(b).
Earned income generally does not include gains from the disposition of property, investment income and other kinds of non service income such as dividends, interest, alimony, social security benefits, pensions and annuities, and service income earned from U.S. government employment. Some kinds of income that may or may not be included in earned income, depending on its characterization, include business profits, rents and royalties. The examples that follow illustrate several of those forms of income. Each example assumes the taxpayer is a qualified individual who is a bona fide resident of a foreign country for an entire taxable year, and that the income is wholly foreign source.71 
71Some of the examples are drawn generally from IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
 Example (23)—Business Services Income
Lawyer is a sole practitioner in a foreign city. He rents office space and copying equipment but owns some of the other office machines. Although he employs several foreign lawyers as associates, his clients generally look to him as the person responsible for the services rendered. The entire amount of his fee income is earned income.72   Taxpayer's modest capital investment in office equipment is not a material income-producing factor, hence the 30% limit does not apply.
72See Regs. §1.911-3(b)(3).
 Example (24)—Business Investment Income
Taxpayer invests in a foreign partnership that manufactures and sells merchandise in several foreign countries. He performs no services in connection with the business. His $80,000 distributive share of partnership net profits is not earned income.
 Example (25)—Service-Capital Business Income
Assume the facts in Example (24) except that Taxpayer is the active manager of the business and devotes full time to its affairs. Because the business is one in which services and capital are material income-producing factors, a portion of Taxpayer's $80,000 distributive share of net profits is earned income. The amount of that earned income is a reasonable allowance for his services, but not in excess of 30% of his share of the net profits; i.e., $24,000. Thus if the value of his services was $40,000 his earned income would be $24,000 or, if their value was $20,000, his earned income would be that amount. Now assume that, notwithstanding Taxpayer's useful services, the partnership had a net loss of $10. If the reasonable value of Taxpayer's services was $40,000, he is entitled to an earned income exclusion of $40,000 because there are net profits.73 
73The 30% limitation applies only if there are net profits. IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
 Example (26)—Partner of a Service Partnership's Foreign Branch
Taxpayer is a partner of a U.S. Big Six accounting firm, resident in the partnership's Rome office. He is entitled to a distributive share of overall partnership income. The partnership agreement does not provide that he is to receive partnership income from a specific source. Personal services alone produce the income of the partnership; capital is not a material income-producing factor. Taxpayer's 20% distributive share of the partnership's overall $300,000 of earned income is $60,000. Assume that 25% of the partnership income ($75,000) was earned directly by the Rome office. Taxpayer's foreign earned income is $15,000 (25% times $60,000). Abashed by being able to exclude only $15,000 of partnership income, in the following year Taxpayer cuts a new deal with his partnership, and in arm's length bargaining the partnership agrees to make a guaranteed payment 74   of $60,000 to Taxpayer as compensation for his services at the Rome office. The full $60,000 he receives Year Two is earned income.75 
74See §707(c), and see ¶4040, above, for a discussion of guaranteed payments to partners.
75See Miller v. Comr., 52 T.C. 752 (1969); Carey v. U.S., 427 F.2d 763 (Ct. Cl. 1970).
 Example (27)—Partner of a Service-Capital Partnership's Foreign Branch
Taxpayer is the partner in charge of a U.S. Big Six accounting firm's London office. Because the firm owns the building in which the London office is located, and because of its sizeable array of computer and telecommunications equipment, the business is one in which services and capital are material income-producing factors. The partnership agreement provides that Taxpayer is to receive his entire distributive share only from the profits of the London branch. That arrangement is reasonable under the circumstances and its principal purpose is not the evasion or avoidance of U.S. tax. The firm's overall profits are $400,000 of which the London office generated $100,000 Taxpayer's distributive share of the firm's profits is 20%, and is treated as derived entirely from the London office profits. His entire $80,000 is foreign source income, and his earned income is a reasonable allowance limited to $24,000 (30% times $80,000).76 
76See Kampel v. Comr., 72 T.C. 827 (1979), aff'd 634 F.2d 708.
 Example (28)—Stock Options
Taxpayer sold stock options. Normally, earned income does not include gain from the disposition of capital assets or other property. However, the options were awarded Taxpayer for services performed for his employer outside of the United States, and the sale was a disqualifying disposition of the options. In that case, the gain is considered compensation received in the year of disposition and earned in the year in which Taxpayer performed the services that led to the award of the options.77 
77See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
 Example (29)—Artist's Income from Sale of Own Works
Taxpayer, an artist, painted still lifes in his studio in Paris. His proceeds from the sale of the pictures were foreign earned income.78   If he had also sold works produced by others, the income from those sales would not have qualified as earned income.79 
78See Tobey v. Comr., 60 T.C. 227 (1973), acq. 1979-1 C.B. 1. Income from the sale of literary rights by the author is similarly characterized. See Rev. Rul. 80-254, 1980-2 C.B. 222. It is an open question whether an artistic work which has a significant material cost would be treated as producing service-capital income, subject to the 30% limitation. See Cook v. U.S., 599 F.2d 400 (Cl. Ct. 1979) (issue raised as to sculptor's materials, but court determined it unnecessary to decide issue). 
79It is unclear whether an artist would receive Tobey treatment if he painted and stockpiled his works and sold a large number of them a considerably later date.
 Example (30)—Rent
Taxpayer owns a boarding house in Paris for artists like Taxpayer in Example (29). If he performs no personal services or only occasional and minor services in relation to the property, the rent is not earned income. However, if he performs significant personal services in relation to the operation of the property, service-capital foreign earned income will result.80 
80To date, no authority exists as to whether the characterization of earned income under Section 911 is affected by the Section 469 passive activity loss rule classifications of taxpayer endeavors.
 Example (31)—Use of Employer's Facilities
Taxpayer lives and works in Tokyo. He receives a monthly salary of $4,000. In addition, he lives rent free in a residence provided by his employer because of the extraordinary cost of rent in Tokyo. The residence is not located near the employer's premises, and Taxpayer does not conduct any business there on his employer's behalf. The fair rental value of the apartment is $2,000 a month. Taxpayer's foreign earned income for the year is $72,000 ($48,000 salary plus $24,000 rental value).81 
81See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. 
2. Excludable Amount
The earned income exclusion is limited for any taxable year.82   The mechanics of applying the limitation require determination in three areas: the computation of the limitation amount by reference to the duration of the taxpayer's presence abroad during the taxable year; dealing with income earned in one year but paid in a different year; and the treatment of married couples and community property income.
82§911(b)(2). The excluded amount was $70,000 before 1998. In 1998, it was $72,000, increasing to $74,000 in 1999, $76,000 in 2000, $78,000 in 2001, and $80,000 in 2002. Beginning in 2008, the $80,000 annual amount will be indexed for inflation. 
a. Part-Year Proration
The Code provides that the available annual limitation is to be computed on a daily basis.83  That poses no arithmetic issue for a qualified individual who meets the bona fide resident test, or for one who meets the foreign personal presence test, and who has been in a foreign country for the entire taxable year in question. However, if the taxpayer qualifies for only part of the year (bona fide resident for less than an entire year, or foreign physical presence for less than 365(6) days), the allowance must be prorated by a fraction the numerator of which is the number of qualifying days and the denominator of which is the total number of days in the taxable year.84
83§911(b)(2)(A).
84Regs. §1.911-3(d)(2). This allocation is not to be confused with the apportionment of income between foreign and nonforeign sources, discussed above in ¶7110, above.
 Example (32)—Bona Fide Resident Part-Year Proration
U.S. Citizen qualifies as a bona fide foreign resident for 75 days in 1997, his calendar taxable year. His exclusion limitation $14,384 (75/365 times $70,000).85   If he is a bona fide foreign resident for another entire year, he is entitled to the full $70 000 exclusion limit (365/365 times $70,000).
85IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. 
 Example (33)—Physical Presence Part-Year Proration
Resident Alien is physically present in a foreign country during a 16-month period from June 1 of Year One through September 30 of Year Two (a leap year), except for 15 days in December of Year One that he spends in the United States on vacation. The maximum exclusion amount is $70,000 in both Year One and Year Two. He realizes that he can choose overlapping periods of 330 days during any consecutive 12-month periods to achieve the maximum numerator of the fractions for both taxable years. After shuffling the numbers, he arrives at the following determination for Year One: (i) Beginning with June 1 of Year One, count forward 330 full days (i.e.,  days in which he spent 24 hours in a foreign country) and arrive at May 10 of Year Two, the 330th day, and the last day of the  12-month period; (ii) count backwards 12 months from May 10 of Year Two to find the first day of the 12- month period, May 11 of Year One; (iii) count the total days in Year One that fall within the Year One portion of the 12-month period (May 11 of Year One through May 10 of Year Two), or 235 days (May 11 of Year One through December 31 of Year One); (iv) multiply $70,000 by 235/365 to arrive at the $45,068 maximum limitation available for Year One. Resident Alien arrives at the following determination for Year Two: (i) beginning with the last full day of foreign physical presence (September 30 of Year Two), count backward 330 full days to arrive at October 22 of Year One, which is the first full day of the new period of 12 consecutive months; (ii) count forward 12 months from October 22 of Year One to find the last day of the 12-month period, October 21 of Year Two; (iii) count the total days during Year Two that fall within the 12-month period October 22 of Year One through October 21 of Year Two, or 295 days (January 1 of Year Two through October 21 of Year Two); (iv) multiply $70,000 by 295/366 to arrive at the $56,421 maximum limitation for Year Two.86 
86IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. But see Regs. §1.911-3(d)(3), which provides a less generous method of computation.  Apparently, the IRS has relaxed its position since publication of the regulations, but has not yet amended them.
b. Treatment of Income Not Received in Same Year as Earned
The second feature of determining the excludable amount is the treatment of income earned in one year but received in a different year. No particular problem arises if the taxpayer is paid completely for his services in the year in which they are performed. However, in the real world, he may perform services in Year One and receive part or full payment in Year Two, or he may perform services over several years and not be paid in whole or in part until a later year.
The general rule starts with the proposition that foreign earned income is income from only sources within a foreign country for services performed while the taxpayer was a qualified individual (that is, a bona fide foreign resident or physically present in a foreign country). As to those services performed in one year but paid for in the following year, when determining the foreign earned income exclusion the income is ordinarily considered to have been earned in the year the services were actually performed. If the taxpayer reports on a cash method, however, the income is not included in his return until it is received. In that case, even though he may no longer be a qualified individual when he gets the income (for example, he is no longer a bona fide foreign resident), the income can be excluded in the year of receipt to the extent it was eligible for the exclusion in the year in which it was earned.87
87§911(b)(2)(B); Regs. §1.911-3(e)(1).
 Example (34)—Timing the Exclusion
U.S. Citizen, a cash method taxpayer, is a bona fide resident of a foreign country during all of Year One and Year Two, during which the maximum annual exclusion is $70,000. In Year One he receives $65,000 for foreign services performed during that year. He can elect to exclude the entire amount. In Year Two U.S. Citizen receives $85,000, of which $10,000 relates to his prior year's services. The $75,000 balance is for Year Two services. In preparing his Year Two return, the taxpayer can exclude $5,000 of the $10,000 received in that year for prior-year services, and the remaining $5,000 is included in Year Two income because the Year One $70,000 limitation would have prevented its exclusion if received in the prior year. Of the $75,000 received in Year Two for services performed that year, $70,000 is available for exclusion. As a result, if the taxpayer elects the exclusion for both years, in filing his Year Two return he can exclude $75,000 ($5,000 plus $70,000) and reports $10,000.88
88See IRS Pub. 54, Tax Guide for U.S. Citizens and resident Aliens Abroad; Regs. §1.911-3(e)(1).
There are a couple of variations on the general theme. First, as the foregoing Example illustrates, income received in the year in which it is earned is applied first to the limitation for that year, and only after that occurs is income earned in the earlier year but received in a later year applied to the limitation for the prior earning year.89
89Regs. §1.911-3(e)(2).
Second, where a year end payroll period is the only reason for rolling the receipt of income into a second year, that income is treated as earned in the year in which it is received for purposes of the limitation amount.90   For that rule to apply, each of the following factors must exist: (i) the period for which the payment is made must be a regular payroll period of the employer, and applicable to the taxpayer; (ii) the payroll period must include the a 1st day of the employee's taxable year; (iii) the payroll period cannot exceed 16 days; and (iv) the payday must come at its normal time in the payroll period. The purpose of so much detail in the rule is to balance administrative expedience against the propensity of taxpayers to make the most of two successive limitation amounts.
90Regs. §1.911-3(e)(3).
Third, while potentially excludable income is always attributed to the year in which it is earned to find out if it fits under the limitation for the earning year, nonetheless, income received beyond the year following the earning year cannot be sheltered by the earning year limitation.91   Thus, in the last Example above, if the taxpayer had received the $10,000 attributable to his Year One services in Year Three, the entire $10,000 would have been included in Year Three income even though there was an excess limitation available in Year One.
91§911(b)(1)(B)(iv).
Consistently, where a bonus or other compensation is received that represents a payment for services performed over several years, it is attributed to each of the earning years to which it relates in determining the exclusion amount for each year.92
92§911(b)(2)(B).
Thus, if a bonus relates to service performed for any past year, the bonus is attributed to each year in its earning period by dividing its amount by the number of calendar months in the earning period and multiplying the resulting amount by the number of earning months in the target taxable year. The taxpayer reports the bonus in the year received, diminished to the extent it is excludable under the limitation available for the year of receipt and the prior year only. The portion of the bonus that ties to service in earlier years is therefore fully taxable, even if there was an excess limitation available in those earlier years.
 Example (35)—Earned Income Bonuses
U.S. Citizen goes to work for an employer who contracts to pay him a $40,000 bonus if he will work in a foreign country for four years. He begins work in the foreign country on July 1 of Year One and continues there until June 30 of Year Five. During the entire period he is a qualified individual and a bona fide resident of the foreign country. U.S. Citizen receives the $40,000 bonus in Year Five. The bonus is attributable to 48 months' service. Assuming available limitations for Year Five and the prior years, in Year Five he is entitled to exclude $5,000 (6/48 times $40,000) from gross income in reference to Year Five, and an additional $10,000 (12/48 times $40,000) by reference to Year Four. The remaining $25,000 is attributable to services performed before the year preceding the year of receipt and cannot be excluded from income.93
93See Regs. §1.911-3(e)(4), Ex. 3. If part of the bonus had been attributable to nonqualifying services, performed in the United States, for example, the $40,000 amount would have been reduced to take that into account (see ¶7130.02.D.2.a, above) before apportioning the earned income remainder to the earning period. 
c. Excludable Income of Married Couples
Several special rules apply in determining excludable income for married couples. If both are qualified individuals, each may make an exclusion election separately as to his income (and as to housing cost amounts, discussed below). The amount of excludable foreign earned income is determined separately for each spouse, and each is entitled to a separate full limitation, determined under the rules set forth above. If they file a joint return, the earned income and limitations are first determined separately, then aggregated on the return.94
94See Regs. §1.911-5(a)(2).
If two qualified individuals are married and reside in a foreign community property jurisdiction, the community property laws are disregarded and the earned income and limitations of each are determined separately by reference to the services performed by each.95
95§911(b)(2)(C); See Regs. §1.911-5(b).
If one spouse is a qualified individual and the other is a nonresident alien, and community property laws apply to the foreign earned income of the qualified individual, (i) earned income is treated as income of the spouse who performed the services, (ii) community business income is attributed to the husband unless the wife substantially controls and manages the business, (iii) partnership community property income is considered to be the income of the partner, and (iv) income  derived from the separate property of a spouse is treated as the income of that spouse.96
96§879.
3. Treatment of Deductions Attributable to Earned Income
Deductions and credits allocable to or chargeable against excluded income are disallowed.97  The obvious reason is to prevent a taxpayer from getting a double benefit by excluding an item of gross income and also using the costs which generated the item to offset other income. However, the disallowance is effective only to the extent of excluded income. That is, if a qualified individual has foreign earned income but chooses not to elect the exclusion, the disallowance provision does not come into play. Similarly, to the extent foreign earned income in excess of the limitation is not excluded, deductions are not disallowed.
97§911(d)(6).
The mechanism for attributing deductions and credits to earned income generally piggybacks that which applies in determining U.S. and foreign source taxable income.98  Thus, expenses, losses and other normally deductible items definitely related to the excluded income are rendered non-deductible. Other deductions that have no direct connection with the excluded income do not come within the reach of the disallowance requirement; for example, personal exemptions, qualified retirement contributions, alimony payments, charitable contributions, mortgage interest,99  and real estate taxes on a personal residence.100
98 Regs. §1.911-6(a) generally cross references to Regs. §1.861-8, discussed above at ¶7110. In doing so, not much attention seems to have been paid to the difference in statutory language in the two operative sections. That is, §861(b) says that U.S. source taxable income is to be determined by taking into account deductions "properly apportioned or allocated to U.S. source gross income] and a ratable part of . . . .other deductions which cannot be definitely allocated to some item or class of gross income." In mild contrast §911(d)(6) provides for disallowance of deduction "properly allocable to or chargeable against" excluded earned income. Arguably, therefore, under §911 there is no statutory warrant for overall apportionment of deductions that are not specifically linked to earned income or that cannot be definitely allocated to a distinct item of earned income. Regs. § 1.911-6 does not entirely accept that statutory distinction. Although an argument was made that the distinction was pertinent in the Brewster cases, referred to below, the courts by-passed the argument.
99Notwithstanding the general rule, presumably deductions like mortgage interest for property used in a service-capital business that generates foreign earned income would fall within the tainted deduction category. Thus the taxpayer who operated the Paris boarding house in Example 30 above, would presumably have a portion of the deduction for his mortgage interest on the property disallowed.
100Regs. §1.911-6(a).
The application of the deduction allocation rules becomes a bit convoluted when it is necessary to apply them to cases in which foreign earned income is received in the year after it is earned, or if foreign earned income exceeds the annual limitation, or where the taxpayer is a part-year bona fide resident, or in the application of the overlapping 12-month period for foreign physical presence taxpayers, or in distinguishing between deductions allowed in arriving at adjusted gross income and itemized deductions, and sometimes a combination of two or more of those factors. The examples that follow illustrate several of the rules, alone or in combination.101  In each it is assumed that the taxpayer is a qualified individual, the income is foreign earned income, and that he has elected the exclusion.
101The examples are loosely based on information in IRS Pub 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, and Regs. §1.911-6(a).
 Example (36)—Earned Income Received in Later Year
Taxpayer received $70,000 of foreign earned income in Year One, all of which was excluded from his gross income. The annual limitation in Year One was $70,000. Under the deduction disallowance rule he did not claim $1,000 in deductions directly attributable to that income. In Year Two, after he filed his Year One return, he received a bonus of $10,000 in payment for his foreign work in Year One. Under the rules described above the bonus is treated as Year One earned income and thus that income was $80,000 for deduction disallowance purposes. If the full $80,000 had been received in Year One, only 7/8 of the deduction attributable to earned income would have been disallowed. Taxpayer can file an amended return for Year One to claim 1/8 of the $1,000 deduction.
 Example (37)—Itemized Deduction Treatment
Taxpayer is an employee. In a year when the limitation was $70,000, he had $100,000 of foreign earned income from personal services and excluded $70,000, thereby reporting $30,000 as gross income. He also had $1,500 of unreimbursed travel and entertainment expense attributable to his earned income, of which $500 was for meals and entertainment, and an additional $500 of deductible miscellaneous expenses for tax return preparation and investment management. All of the expenses qualify as itemized deductions (that is, deductions from adjusted gross income, subject to the regular Code limitations for such deductions,102   entered on Schedule A of his individual return). To properly report those items, Taxpayer first completes Form 2106 (Employee Business Expenses) on which he reduces his $500 of deductible meal and entertainment expenses to 50% ($250). He then reduces the remaining $1,250 ($1,000 plus $250) of travel and entertainment expense by $875 ($70,000/$100,000 times $1,250) to reflect their disallowance as related to excluded earned income. The $375 remainder is reported as a miscellaneous deduction on Schedule A together with the $500 of other deductible expense. Next, Taxpayer computes the 2% limitation on itemized deductions of $600 ($30,000 times .02) and reduces the $875 of itemized deductions ($375 plus $500) by that amount to arrive at available deductions of $275.
102See ¶2910, above, for a discussion of the treatment of itemized deductions of the sort described here.
 Example (38)—Service Business Deductions
Taxpayer is the self-employed proprietor of a foreign service business in which capital was not a material income-producing factor. In a year when the limitation was $70,000, his business gross income was $100,000, business expenses were $60,000 and the resulting net profit was $40,000. He excludes $70,000 from gross income. Since his excluded income is 70% of gross income, 70% of his business expense on Schedule C of his individual return, and on Form  2555 (Foreign Earned Income) he reports $70,000 as the excluded  amount reduced by $42,000 (.70 times $60,000) for the disallowed business  expenses. The net amount is carried forward to Form 1040.
 Example (39)—Service-Capital Business Deductions
Assume the facts in the previous Example, except Taxpayer's business is one in which capital is a material income-producing factor. His earned income is limited to 30% of net profit (discussed at ¶7130.02.D.1 above); i.e., $12,000. Assume that is a reasonable allowance for  his services. His business deductions are therefore disallowed to the extent  of $7,200 (.12 times $60,000).
 Example (40)—Service-Capital Business Loss
Assume the facts in the previous example, except Taxpayer's business gross income was $140,000 and his business expenses were $170,000 with a resulting $30,000 net loss. A reasonable allowance for Taxpayer's services is $75,000. Because there is a net loss, the 30% net income limit does not apply. Thus, taxpayer's foreign earned income is $75,000. If he elects the earned income benefit, he can exclude $70,000 (the limitation amount). Since the excluded amount is 50% of gross business income ($70,000/$140,000), $85,000 of the business expenses are disallowed (.50 times $170,000). To report that result, Taxpayer includes total business income and expense on Schedule C of his individual return. On Form  2555 he shows the $70,000 earned income exclusion, the $85,000 expense disallowance, and carries the $15,000 balance to his return as additional income item.
Comment: The Example above indicates a serious pitfall for the unadvised. On the facts stated, the net effect of the election to exclude earned income was to reduce the net operating loss for the year from $30,000 to $15,000. While no tax would be due, nonetheless his loss carryover to other years was forever diminished with no countervailing benefit. Now assume that Taxpayer had $30,000 of additional gross income, other than from his business. If he did not elect the earned income exclusion, his $30,000 net business loss offsets the other gross income, resulting in zero taxable income for the year. But if he elects the exclusion, on the facts in the Example his net business loss available to offset the $30,000 other income is $15,000, leaving taxable income of $15,000.103  Consider this in the light of the discussion below on when to elect the earned income exclusion.
103See Brewster v. Comr., 55 T.C. 251 (1970), aff'd, 473 F.2d 160 (D.C. Cir. 1972); Brewster v. Comr., 67 T.C. 352 (1976), aff'd, 79-1 USTC ¶9398 (D.C. Cir. 1979), cert. denied, 444 U.S. 991 (1979).
 Example (41)—Partnership Deductions
Taxpayer is a partner in a foreign partnership in which capital is not a material income producing factor. The partnership agreement says that Taxpayer will receive 50% of partnership net profits. In a year when the maximum exclusion was $70,000, partnership entire gross income of $200,000 was foreign services income, its business expenses were $80,000, resulting in net profit of $120,000, of which Taxpayer received $60,000 as his distributive share. He elects the foreign earned income exclusion and is thereby entitled to exclude $70,000 (the limitation amount) of his $100,000 share of partnership gross income. His share of partnership expenses is reduced by $28,000 ($80,000/2 times $70,000/$100,000). To report the results of his election, he includes the $60,000 which is his share of partnership net profits on Schedule E of his individual return, and on Form 2555 he reports the exclusion of  $70,000, the $28,000 of disallowed deductions, and carries the net amount of  $42,000 to his Form 1040 as a reduction of gross income.
4. Disallowance of Foreign Tax Credit
Foreign taxes paid on foreign earned income excluded from gross income cannot be claimed as a credit against U.S. tax, or as a deduction in arriving at taxable income.104  If only a part of a qualified individual's foreign earned income is excluded (for example because of the annual limitation), the foreign income tax attributable to the earned income included in gross income is creditable or deductible. To determine the foreign tax available for credit or deduction, the total foreign tax attributable to earned income is multiplied by a fraction the numerator of which is excluded foreign income minus deductible expenses allocable to that income (but not including the foreign housing cost amount deduction, if any). The denominator of the fraction is total foreign earned income minus all deductible expenses allocable to that income (including the foreign housing cost amount deduction, if any).
104§911(d)(6).
The product is the amount of foreign tax rendered unavailable for credit or deduction. If the foreign tax applies not only to foreign earned income but also to other income (interest, for example) and the taxes on that income cannot be broken out, the denominator of the fraction is the total amount of income subject to the foreign tax less deductible expenses allocable to that income.105
105Regs. §1.911-6(c).
 Example (42)—Foreign Taxes Disallowed
U.S. Citizen is a self-employed qualified individual who had a bona fide residence in Foreign Country for an entire taxable year. In a year when the maximum exclusion was $70,000, he received foreign earned income of $140,000 during the year and paid $40,000 in business expenses. He properly elected to exclude foreign earned income in an amount equal to the $70,000 limit, and claimed a housing cost amount deduction of $15,000. He also had $10,000 of interest income which, together with his earned income, was included in his Foreign Country unitary tax base. He paid $30,000 in Foreign Country income tax. U.S. Citizen allocated $20,000 of his business expenses ($40,000 times $70,000/$140,000) to his excluded earned income. The Foreign Country tax rendered unavailable as a credit or a deduction is $15,789, computed as follows: $30,000 times $50,000 ($70,000 excluded earned income less $20,000 allocable expense), divided by $95,000 ($140,000 total earned income less $40,000 deductible expense less $15,000 housing cost deduction interest plus $10,000 interest income).105.1 
105.1See Regs. §1.911-6(d), Ex. 5.
When a taxpayer makes a §911(a)(1)  election, and subsequently reports income that was excludable under the  election and claims a foreign tax credit with respect to that income, the  election is revoked. If, when the taxpayer was eligible for  §911 treatment, he elected to exclude his  §911(a)(2) housing cost amount, one or  both of the elections may be revoked depending on the amount of the tax credit  claimed. If the credit claimed is greater than or equal to the amount of both  election amounts, both elections are revoked; if the credit claimed is greater  than the housing cost but less than the  §911(a)(1) election, the  §911(a)(1) election is revoked and the  housing cost exclusion is not revoked; and if the credit claimed is less than  or equal to the housing cost exclusion, the taxpayer may choose which election  has been revoked. Good faith computational errors made in determining the  amount of foreign earned income excludable, which may affect the amount of  the allowable foreign tax credit, do not revoke the  §911 election.106
106Rev. Rul.  90-77, 1990-2 C.B. 83.
¶7130.02.E. Treatment of Foreign Housing Costs
A qualified individual (that is, a person with a foreign tax home who is either a U.S. citizen who is a bona fide foreign resident, or a U.S. citizen or resident alien who meets the foreign physical presence test) is entitled to make a separate election to exclude or deduct statutorily identified housing cost amounts from gross income. While that treatment is distinct from, and may be in addition to, the foreign earned income exclusion discussed above, if the taxpayer chooses the housing amount exclusion he computes and applies it first, then the foreign earned income exclusion. That is, the exclusion limit is first reduced by the housing cost exclusion, and the earned income exclusion is available only to the extent of the remainder.107 A qualified  individual can exclude housing cost amounts only if his housing expenses are  provided by his employer. If the employer does not provide a housing allowance,  or if the taxpayer is self employed, he can deduct his housing cost amounts. 108 If he uses the deduction, the annual exclusion limitation is not directly reduced, but  as described below, another limitation may apply to restrict the deduction.
107§911(a)(2), (c); Regs.  §1.911-4(d). 
108§911(c)(3)(A).
The housing cost amount on which the exclusion is based is equal to the excess of the taxpayer's housing expenses over a base housing amount. For that purpose, housing expenses are the reasonable expenses paid or incurred during the taxable year for housing in a foreign country. The expenses are those paid by or on behalf of the taxpayer, and his spouse and dependents if they live with him. They include, variously, expenses attributable to housing such as utilities (other than telephone) and insurance, rent or the fair rental value of employer-provided housing, repairs, nondeductible occupancy taxes, furniture rental, and residential parking. Housing expenses do not include expenses that are lavish, extravagant or outrageous (taking account of the taxpayer's circumstances), deductible interest or taxes, the cost of buying property (including mortgage payments), domestic help, capital improvements to the residential premises, or purchased furniture.109   Nor do they include the cost of two foreign households, except as described below.
109§911(c); Regs. §1.911-4(b)(1) and (2). 
The base housing amount, which the above expenses must exceed, is 16% of the annual salary of a U.S. government employee, GS-14, step 1. That salary is determined yearly on January 1. For example, if the applicable salary amount were $54,607, the resulting base housing amount would be $8,737.12 (.16 times $54,607). The base amount is computed on a daily basis ($23.94 for the above income figure) for the days the taxpayer meets the bona fide foreign residence or foreign physical residence or foreign physical presence tests, described above.110
110§911(c)(1)(B); Regs. §1.911-4(c). See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
 Example (43)—Foreign Housing Amount
Taxpayer qualifies for the housing cost exclusion for the entire 1992 taxable year. His reasonable foreign housing costs are $12,500 in that year. The foreign housing amount is $3,762.88 ($12,500 minus the 1992 base amount of $8737.12). Now assume the qualified taxpayer barely meets the foreign personal presence test for 1992, being in a foreign country or countries for 330 days, and his foreign housing costs were $11,029 for that period. His foreign housing base amount is $7900.20 (23.94 times 330), and his foreign housing cost amount is $3,128.80.
Foreign housing expenses provided by the taxpayer's employer, either through payments made directly to the taxpayer or by payments made on his behalf, are included in the employee's gross income under the regular rules of the Code.111
111Amounts that a U.S. taxpayer stationed abroad generally is required to include in gross income are salary, reimbursements for housing expenses, amounts the employer pays to a third party for the employee's housing, the fair rental value of employer-owned housing (unless that item is excluded from the employee's income under the convenience-of-the-employer rule of §119), amounts paid to the employee under a tax equalization plan, and amounts paid to the employee or to a provider for the education of dependents.
After making the computation described above, the taxpayer can elect to exclude his housing cost amount from gross income. That exclusion is not limited to the maximum exclusion for foreign earned income. However, as noted above, the housing cost amount diminishes that limitation on a dollar-for-dollar basis in terms of the application of the limitation to foreign earned income.112  Note too that while 100% of the employer-provided housing expenses are included in gross income, because the taxpayer can exclude only amounts in excess of the base housing amount, the taxpayer does not net out at zero when he elects to exclude housing costs. Since the housing cost and earned income exclusions are separate elections, in some cases it may be to the taxpayer's advantage to elect the earned income exclusion (which is dollar-for-dollar up to the earned income exclusion limit) and forego the housing cost exclusion. The regulations require that all qualified housing cost amounts must be excluded once an election for them is made. A partial exclusion is not permitted.113
112 The reason should be fairly obvious. Since foreign housing expenses paid by the employer are included in foreign earned income, the application of excluded housing cost amounts to the earned income limitation prevents the taxpayer from getting a double benefit.
113Regs. §1.911-4(d)(1).
As a general rule, a taxpayer can exclude the housing cost amounts of only one foreign residence. Normally, that is the one which is his tax home. If the taxpayer maintains a second foreign household where his spouse or dependents reside but he does not, however, housing cost amounts in relation to the second residence can be included in the exclusion, but only if he maintains the second residence because living conditions where he resides are dangerous, unhealthful, or otherwise adverse. Those bad circumstances include a state of warfare or civil insurrection, or may occur if the taxpayer is required to reside at the premises of his employer at a place or in a manner which is not conducive for his dependents or spouse to live with him; for example, on a drilling rig or at a remote construction site. In no event, however, can the cost of more than two households be taken into account for purposes of the exclusion.114
114§911(c)(2)(B); Regs. §1.911-4(b)(5).
A qualified individual can deduct housing cost amounts (described above) if his employer does not provide them (and they therefore are not included in his earned gross income), or if he is self-employed. The housing cost amount deduction can be claimed only to the extent that foreign earned income is greater than the sum of the earned income exclusion and the housing cost amount exclusion for any taxable year. To the extent that a deductible housing cost amount cannot be used because of that limitation, the unused amount can be carried forward to the following year, but not beyond that.115
115§911(c)(3); Regs. §1.911-4(e).
If a taxpayer is both an employee for whom an employer has provided housing cost amounts, and a self-employed person during the same taxable year, he may be able to claim the exclusion and the deduction. To compute the amounts involved, the taxpayer first determines the exclusion by multiplying his housing cost amount by the portion provided by the employer, then dividing the result by his total foreign earned income. The remaining balance is deductible, subject to the limitation described in the preceding paragraph.116
116Regs. §1.911-4(d)(3).
If a husband and wife are both qualified individuals, and maintain separate households, each may be able to claim a housing cost exclusion or deduction. To do so, each must have a discernible tax home that is not within reasonable commuting distance of that of the other spouse. In that case, the housing cost amount exclusion or deduction is computed separately for each spouse. If both claim housing cost amounts, then neither can include the costs of a second foreign home. But if one spouse does not claim his housing cost amounts, the other spouse can claim costs of a second foreign home (if the tests for the second home are met).117 
117Regs. §1.911-5(a)(3)(ii).
 Example (44)—Spouses Reside Apart
Husband and Wife are both qualified individuals. Their tax homes are in London and Paris, respectively. Although both can exclude or deduct their housing cost amounts, they must make separate computations even though they file a joint return. Neither can claim the other's residence as a second foreign home (and as a result, they suffer the detriment of having to diminish housing costs by two separate base housing amounts). Now assume that Wife lives in an area where there are adverse living conditions (discussed above) and Wife maintains a home for Husband in London. In that case, Wife can add treat the London residence as a second foreign residence and add its housing costs to hers, thereby using only one base housing amount. However, in this case Husband cannot claim any housing cost amount exclusion or deduction.118
118See Regs. §1.911-5(a)(3)(ii); see also IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
If two qualified individuals are husband and wife and live together, file a joint return, and have housing cost amounts, they can compute the housing amounts on either a joint or separate basis. If they file separate returns, they have to make separate computations. Where separate computations are made in either case, the two taxpayers can allocate the housing expenses to one, or the other, or divide them as they choose.119  However, each spouse must use his own full base housing amount. (Bear in mind that the base amount may be different for each, depending on the number of days of foreign presence.)
119Regs. §1.911-5(a)(3)(i).
If they make a joint computation, only one can claim the exclusion or deduction, but they can decide who does so. (The choice probably will depend on the amount of the foreign earned income of each.) If the spouses have different periods of foreign residence or presence for the taxable year, and the one with the shorter measuring period claims the exclusion or deduction, only the expenses incurred in his shorter period can be claimed as housing expenses.120 
120Regs. §1.911-5(a)(3).
 Example (45)—Joint and Separate Computations
Husband was a qualified individual and a bona fide resident of a foreign country from August 17 of Year One through December 31 of Year Two. Wife joined him and became a qualified individual and a bona fide resident of the same foreign country on September 15 of Year One and lived with him there through December 31 of Year Two. During Year One Husband and Wife received $50,000 and $25,000 of foreign earned income, respectively. For that year he paid $10,000 for qualified housing expenses of which $7,500 was for expenses incurred from September 15 through the end of the year. After Wife arrived, she paid $3,000 in similar expenses for Year One. If the couple computes their housing amount jointly on their Year One joint return, and Husband claims the exclusion, their housing expenses total $13,000. Using Husband's base period of residence (because it is longer than Wife's) the base housing amount is $2,918.10 (137 days times $21.30 (based on the GS-14 salary for that year)) and his housing cost amount is $10,081.90 ($13,000 minus $2,918.10). In contrast, if Wife claims the housing exclusion their housing expenses would be $10,500 $7,500 plus $3,000), using her period of residence their base period amount would be $2,300.40 (108 days times $21.30), and her housing amount would be $8,199.60 ($10,500 minus $2,300.40). In the third alternative, if they compute their housing amounts separately on their Year One joint return, their separate housing amounts would be as set forth above, and they can decide between them how to divide the $13,000 total housing expenses.121  In Year Two, as described below, they must elect to exclude, but they need not adopt the same method they used in Year One.
121See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
If the housing cost amount exclusion is elected, deductions and credits attributable to the excluded income are disallowed. See the discussion of this subject above. However, the housing cost amount deduction is not considered related to excluded income for that purpose.
¶7130.02.F. Electing Exclusions 
A taxpayer can, but need not, elect one or the other, both, or neither, of the exclusions described above. An election is made by filing Form  2555 (or Form 2555-EZ if there is no claim for the foreign housing exclusion) with a timely individual income tax return (Form  1040), or on an amended return filed to replace a timely return,  or on an original return that is not timely filed if the late original return  is filed within one year of the due date for the taxable year in question  (without regard to any extension of time to file the original return).122  However, an indefinite extension of these periods is provided, so long as the IRS does not discover that the taxpayer failed to elect the exclusion in a year where the taxpayer would owe tax after the exclusions. 123
122§911(e); Regs. §1.911-7(a)(3).
123See Regs.§1.911-7(a)(2)(i)(D). See also CCA 200226010 (For purposes of determining whether tax is owed within the meaning of Regs. §1.911-7(a)(2)(i)(D), taxpayer entitled to credit tax payments and withholdings).
Once an election is made to exclude foreign earned income or housing cost amounts, the election remains in effect for the first year and all later years until it is revoked. In contrast, no election is necessary to claim the housing cost amount deduction.124
124§911(e)(1); Regs. §1.911-7(a)(3).
A taxpayer who has an exclusion election in effect can revoke it for any taxable year. The revocation is made separately with respect to the foreign earned income exclusion and the housing cost amount exclusion by attaching a statement to the return (or amended return) for the first taxable year for which the revocation is to be effective.125  Without the consent of the IRS,126  the taxpayer cannot again elect the exclusion until the sixth year following the year of revocation.
125§911(e)(2); Regs. §1.911-7(b). If the taxpayer elects an exclusion, then amends the return for the year of the election, the amended return should not constitute a revocation unless a revocation statement is attached; i.e., the amended return would not cancel  out the requirement that the exclusion be used (if available) on returns filed  for later years. For example, assume Taxpayer elects the foreign earned income exclusion for Year One, files a return for Year Two which uses the exclusion, then in Year Three amends the Year One return to erase the election for that year. Presumably the Year Two return would be treated as the initial election and the Year Three return would continue to be subject to the election unless the taxpayer affirmatively revoked the election with the Year Three return.
126§911(e)(2); Regs. §1.911-7(b)(2). In order to reelect within the hiatus period, the taxpayer requests a ruling from the Associate Chief Counsel (International), Internal Revenue Service, Attn: CC:PA:T P.O. Box 7604 Ben Franklin Station, Washington, D.C. 20044. Grounds for approval may include a period of U.S. residence, a move from one foreign country to another with different tax rates, a substantial change in the tax laws of a foreign country of residence or physical presence, and a change of employer. Id.; see IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. See PLR 200025019 (Taxpayers may reelect §911 exclusion before sixth year after the year in which revocation was made when there is substantial change in foreign country's tax laws such as declaration of tax holiday); PLR 200416007 (Permission to reelect §911 granted-taxpayer moved to a country with differing tax rates and changed employment). See also PLR 200346015 (Spouses elected §911 in timely 1999 return but later, without being informed of consequences of revoking election, filed amended 1999 return prepared by different accountant claiming foreign tax credits in lieu of §911; concerned about second accountant's expertise in international issues, however, spouses engaged third accountant for 2000 return and per his advice obtained IRS ruling allowing reelection of §911 for 1999, citing taxpayer's reliance on professional advice).
Whether or not to elect either or both of the two exclusions is normally a numbers game, hence no hard and fast rules apply. As a general proposition, if the foreign earned income is subject to foreign tax, the exclusion decision is essentially a trade-off that depends on whether a direct credit against U.S. tax (arrived at by including the entire amount of foreign earned income in U.S. gross income) for the foreign taxes paid produces a lower overall tax liability than excluding foreign earned income from the U.S. tax base and foregoing the credit for all or some of the foreign income tax paid on that earned income. A complicating factor, of course, is whether the limitation on the foreign tax credit (discussed below) would render a portion of the foreign tax unavailable as a credit in the current year and, if so, whether the foreign tax in excess of the foreign tax credit limitation might be available as a carryover in another year.127
127To some extent, the interplay among (i) the taxpayer's ability to revoke his §911 exclusion election at a later date, (ii) or to make the election retrospectively by amending prior year's returns, and (iii) the somewhat similar ability within the window in time provided by the statute of limitations to change the election to credit or deduct the foreign tax, plus (iv) the carryover period for creditable but currently unusable foreign tax permit the taxpayer some flexibility in massaging the numbers.
A rough rule of thumb is that if the foreign tax rate applicable to foreign earned income is lower than the U.S. tax rate on that income, it is probably beneficial to elect exclusion. Whether either or both exclusions should be elected is essentially a function of the application of the annual exclusion limitation. Conversely, if the foreign tax rate on the taxpayer's foreign earned income is higher than the U.S. tax rate on that income, it may be desirable to forego the exclusion and take the credit. However, the application of the foreign tax credit limitation baskets, which act to avoid averaging of foreign income tax rates, may come into play to prevent the use of the entire amount of the foreign tax credit in the current year, thereby shifting the focus of inquiry to the taxpayer's potential ability to use the carryover credits in another taxable year.
Finally, perhaps the most certain of the variables is that the exclusion election should be avoided if the taxpayer is the proprietor of or a partner in a service-capital business that can be expected to generate a loss. As noted above in Example 40, in that circumstance the exclusion election has the effect of causing the disallowance of a portion of the loss that would otherwise offset other current income.
¶7130.02.G. Filing Returns While Foreign Status Is in Doubt
On occasion, a taxpayer may want to make one of the exclusion elections, but at the time the return is due to be filed he may be unable to determine whether he qualifies under the bona fide foreign residence test or the foreign personal presence test. At that point he has several alternatives. First, if the taxpayer is a U.S. citizen or resident alien whose tax home and abode is outside of the United States or Puerto Rico he is given an automatic two-month extension of time (without the necessity of filing an application), within which to file his return and pay any tax due. For a calendar year taxpayer, the automatic extension would be to June 15 of the year following the taxable year.128
128Regs. §1.6081-5. As a condition of the extension, the taxpayer must include a statement with his return when it is filed, providing sufficient facts to support his entitlement to the extension. He is not disqualified from the benefit of the extension simply because he is in the United States on the due date of the return, or at any other time. The extension also applies to the payment of tax. Id.
Second, if the taxpayer expects to meet the bona fide foreign resident or personal presence tests, but two months is not enough to make a proper determination, and if his tax home was in a foreign country or countries throughout his period of bona fide residence or physical presence, he can request an additional extension of time on Form 2350. The form is to be filed before the due date of the return (ordinarily as extended by the 2 month rule referred to in the preceding paragraph). However, unlike the automatic extension, the Form 2350 extension for filing does not extend the time for payment. If the taxpayer has not paid enough tax (e.g.,  through wage withholding or estimated tax), he must include the balance due  with the extension form. Late payment penalties may apply to the extent of  any shortfall.
In completing Form 2350 the taxpayer enters the date on which he expects his qualifying period to end. If the IRS grants an extension, it will normally be to a date 30 days after the time at which the taxpayer expects to determine whether he meets the appropriate presence test. If the extension request is denied, normally the taxpayer is given a 45-day grace period in which to file. In some cases, however, the grace period will not be accorded the taxpayer. If he has not filed, he is just plain late.129
129Form 2350.
If the taxpayer uses the automatic 2-month extension, but does not expect to be able to meet either foreign status test, he can get an additional two months by filing Form 4868, the regular automatic extension form. However, it does not extend the time for paying any tax due.
As a final alternative, if the taxpayer is unable to determine his foreign status, he can file his return on time and later amend it, as described above. If the return is filed before the taxpayer actually meets one of the foreign status tests, however, the IRS says that the taxpayer cannot claim either the foreign earned income or the housing cost amount exclusions on the return. Instead, he is to include all of his foreign earned income and later file a claim for refund when he has become certain that he can properly elect either or both of the exclusions.130
130IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. 
¶7130.02.H. Related Matters
1. Moving Expenses
The Code permits a taxpayer to claim a deduction from gross income for expenses incurred in moving to a new job location. In addition, if the taxpayer is reimbursed by his employer for the expense of the move, the amount is included in his gross income. In a domestic setting, those rules produce no extraordinary surprises. They may, however, in a context in which it is necessary to determine the source and character of income, and the non-calendar time period to which a payment relates.
The moving expense deduction is available to an employee or self-employed person in connection with his commencement of work at a new principal place of work. Deductible moving expenses generally include the reasonable cost of:131
•   Moving household and personal goods (including packing, storage while in transit, insurance and other similar items) of the taxpayer and his household members. For foreign moves,132  household moving costs can include reasonable expenses of moving goods to and from storage, including storage for part or all of the time the taxpayer's new place of work abroad continues to be his principal work place.
•   Transportation, meals, and lodging for the taxpayer and his household members for one trip from his former home to this new home, except that meal costs during the trip are not deductible.133
131§217.
132§217(h) See Regs. §1.217-2(b) and (h). The discussion of moving expenses in the text focuses only on their application to qualified individuals and thus glosses over a number of specific rules. See the more detailed discussion of moving expenses at ¶2870, above. A foreign move is one in connection with the commencement of work by the taxpayer at a new principal place of work outside the United States or one of its possessions. Thus it includes a move from the United States to a foreign location, and from one foreign country to another. It does not include a move from a foreign country back to the United States or a possession. Regs. §1.217-2(h)(3).
133§217(b)(1). 
Household members include anyone who has both the taxpayer's old home and his new home as his or her home. Tenants and employees are not household members unless they are the taxpayer's dependents. 133.1 
133.1§217(b)(2).
Although foreign moves generally do not include a move from a foreign location to the United States, they do include the return to the United States of someone who retires while outside the United States.134  Somewhat similarly, the spouse or dependent of a decedent whose principal place of work was abroad at the time of his death can deduct expenses of moving back to the United States. To qualify, the move must begin within six months from the decedent's death and must be from a foreign home in which the claimant lived with the decedent.135
134See Regs. §1.217-2(i)(2).
135Regs. §1.217-2(i)(3).
Because deductible moving expenses are incurred in connection with beginning a new job, when the new job location is in a foreign country, the moving expenses are considered to be directly connected with the income earned in that foreign country. When that income is foreign earned income, and a qualified individual incurs the moving expense, if he elects one of the exclusions described above the part of the moving expense allocable to that income is not deductible. Moving expenses are considered to be connected to foreign earned income if in the year of the move the taxpayer qualifies under either the bona fide foreign residence or foreign physical presence tests for at least 120 days during the taxable year.136
136Regs. §1.911-6(b).
If the taxpayer does not so qualify for 120 days, the moving expense is considered to be connected with earning income in two taxable years. That is, the moving expense is connected with the year of the move and with the following year if the move is from the United States to a foreign country. Or, if the move is from one foreign country to another, the expense is considered connected with the year of the move and the preceding year.137
137Regs. §1.911-6(b)(2).
 Example (46)—Moving Expense U.S. to Foreign, No Reimbursement
U.S. Citizen, a cash basis taxpayer, arrived in Foreign Country on November 1 of Year One to look for work. He paid $6,000 of reasonable moving expenses in that year. He found a job in Foreign Country, settled at his principal place of work on December 1 of the same year and thereby established a foreign tax home at that time. He actually began his new job on January 4 of Year Two, but he was unsuccessful in convincing his employer to reimburse him for his moving expenses. He had U.S. source income of $30,000 but no foreign source earned income in Year One. He worked abroad during all of Year Two and was paid $80,000 for his services. He met the bona fide resident test on December 31 of that year. In his Year One return he deducted the $6,000 moving expenses (against his U.S. source income). In his Year Two return he elected to exclude $70,000 (the limitation amount in Year Two) of his earned income. He then amended his Year One return to decrease the moving expense deduction by $5,250 ($6,000 times $70,000/$80,000) to reflect the fact that his moving expenses were attributable in part to his excluded foreign earned income.138
138See Rev. Rul. 75-85, 1975-1 C.B. 239, amplified by Rev. Rul. 76-162, 1976-1 C.B. 197.
Reimbursement by an employer for foreign moving expenses is includable in the employee's gross income. In the absence of credible evidence to the contrary, the regulations create a presumption that the reimbursement is attributable to future services to be performed in the new place of work. Accordingly, moving expense reimbursement for a move from the United States to a foreign country is considered attributable to services performed there. Similarly, an employer's reimbursement for moving expenses from a foreign country to the United States are attributed to services performed in the United States.139
139Regs. §1.911-3(e)(5)(i). Evidence to the contrary includes a written agreement between the employer and the employee, or a written statement of company policy, entered into before the move to induce the employee to relocate, to the effect that the employer will reimburse the employee for moving expenses incurred in returning to this country, regardless of whether the employee continues to work for the employer. Id. 
If the reimbursement income is foreign earned income then, like the 120 day rule described above for deductible moving expenses, the reimbursement income is considered attributable to services performed in the year of the move as long as the employee is a qualified individual for a period that includes 120 days in that year. If the employee is not a qualified individual for that period, and the move is from the United States to a foreign country, he treats a portion of the reimbursement as attributable to services performed in the year of the move and the rest as attributable to the succeeding taxable year. And if the nonqualified employee moves from a foreign country to the United States, the reimbursement income is split between the year of the move and the preceding taxable year.140
140Regs. §1.911-3(e)(5)(ii).  Reimbursement income is attributed to the year of the move by the ratio (qualifying days in the year of the move)/(number of days in the year of the move). Id.
Once the reimbursement income is slotted into its appropriate year or years, if the taxpayer elects to exclude foreign earned income (including any reimbursement income), the moving expense deduction regime described above kicks in.
 Example (47)—Moving Expense U.S. to Foreign, with Reimbursement
U.S. Citizen's employer transfers him to a foreign post of duty as of November 1 of Year One. He continues to work there during all of Year Two and qualifies as a bona fide foreign resident for that taxable year. In Year One U.S. citizen pays $6,000 in moving expenses and is fully reimbursed by his employer in that year. His only income is $14,000 in wages earned and paid in Year One after the date he moved and $80,000 earned and paid in Year Two. The earned income exclusion in Year Two is $70,000. He elects to exclude the maximum amount from earned income and has no housing cost amount exclusion. Because U.S. Citizen did not meet the bona fide foreign resident test for at least 120 days in the year of the move, the moving expenses are attributable to both years. His total foreign earned income for both years is $100,000 ($6,000 plus $14,000 plus $80,000). The amount he can exclude from income is $81,699 composed of the $70,000 exclusion for Year Two (the limitation amount) and $11,699 as a part-year exclusion for year One (the $70,000 limitation for Year One pro rated on a daily basis (61 qualifying days/365 total days)). The part of the moving expense deduction that is disallowed is $4,902 ($6,000 times $81,699/$100,000). Note that since U.S. Citizen is a cash basis taxpayer he reports the full amount of the moving expense reimbursement income, and adjusts the deduction for the disallowance on his Year One return. The attribution arithmetic is applicable only to compute the amount of foreign earned income eligible for exclusion in each year, and the amount of the deduction disallowance.141
141See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
When a taxpayer's moving expense is attributable to the year of the move and the next year, as in the Example above, in order to file a return for the year of the move the taxpayer can request an extension of time within which to file that return until after the end of the following year when, presumably, he has enough information to report correctly. (See the discussion above of return filing when the taxpayer's status is indefinite.) If the taxpayer chooses not to request an extension, he can compute the part of the entire moving expense deduction that is disallowed by multiplying the moving expenses by a fraction the numerator of which is the excluded foreign income for the year of the move, and the denominator of which is the total foreign income for the year of the move.
Later, when foreign earnings and the exclusion for the year after the move are known, the taxpayer files an amended return to adjust the moving expense deduction for the year of the move. In the alternative, he can recapture the unallowable amount of his moving expense deduction originally claimed by increasing his income in the year following the move in an amount equal to the unallowable part of the original deduction. On the other hand, if it appears in the second year that the deduction claimed in the year of the move was not enough, an amended return for that year can be filed. He cannot claim the additional deduction in the second year.142 
142See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. And see Rev. Rul. 75-84, 1975-1 C.B. 236 (U.S. to foreign same employer, foreign to U.S. same employer, foreign to U.S. different employer, foreign to U.S. to retire). 
 Example (48)—Moving Expense Foreign to Foreign with Reimbursement
U.S. Citizen was employed by U.S. Corp in its foreign office in Foreign Country One for several years until May 30 of Year One. On June 1 of that year, U.S. Citizen moved to Foreign Country Two and began work there for U.S. Sub, an affiliate of U.S. Corp. He continued that employment for the remainder of Year One and for all of Year Two. U.S. Citizen incurred moving expenses of $6,000 in Year One and was reimbursed for them by U.S. Sub in that year. Because the deduction for moving expenses is conditioned on services performed at the new place of employment, moving expenses are allocable to compensation for services performed at the new job. As a result, U.S. Citizen's moving expenses are allocable to his foreign earned income for the period from June 1 of Year One to December 31 of Year Two.143
143See Rev. Rul. 76-162, 1976-1 C.B. 197.
Under the rule just described, when the taxpayer is transferred from a foreign post of employment to the United States, reimbursed moving expenses are generally U.S. source income and not foreign earned income. Since U.S. source income is not eligible for the exclusion there is no necessity to attribute the expenses to foreign earned income.144
144See Rev. Rul. 75-84, 1975-1 C.B. 236.
However, as noted above, if the taxpayer and his employer agree in advance of his transfer to a foreign post of employment that expenses of moving back to the United States will be reimbursed, the reimbursement may be foreign source earned income.145 
145See Dammers v. Comr., 76 T.C. 835 (1981).
2. Meals and Lodging Costs
The value of meals and lodging provided to an employee (and his spouse and dependents) by an employer for its convenience and on its premises is not included in an employee's income.146  When the lodging is supplied by the employer at a camp in a foreign country, the camp is considered to be part of the employer's premises.147   For this purpose a camp is lodging if the camp is:
•   Provided by or on behalf of the employer for its convenience because the place at which the employee performs services is in a remote area where satisfactory housing is not available to him on the open market within reasonable commuting distance;
•   Located as near as is practical to the place where the employee renders services; and
•   Furnished in a common area or enclave that is not available to the general public for lodging, and normally accommodates 10 or more employees.
146§119(a). Meals must be provided on the employer's premises in order to be excludable. To exclude the value of lodging, the employee must be required to accept it as a condition of his employment. Id.
147§119(c).
If the employee has the option to receive additional compensation instead of meals or lodging in kind, the value of the meals and lodging must be included in the employee's gross income, and for a qualified individual that amount would be foreign earned income.148
148§119; Regs. §1.119-1.
3. U.S. Wage Taxes
U.S. employers generally are required to withhold U.S. income tax from compensation of U.S. individuals who are employed abroad, unless the law of a foreign country requires the employer to withhold and pay over foreign income tax. U.S. employers do not have to withhold U.S. income tax to the extent that the employee elects the foreign earned income or housing credit amount exclusions. To obtain reduced withholding for that purpose the employee submits a statement to his employer, usually on Form 673,  to the effect that he has good reason to believe he will qualify for the  exclusions under the bona fide foreign resident or foreign physical presence  tests.
U.S. social security taxes generally apply to wages for services performed as an employee outside the United States:
•   By a U.S. citizen or resident alien who works for an American employer, or for a foreign affiliate of an American employer under a voluntary agreement entered into between the American employer and the Treasury.
•   On or in connection with an American vessel or aircraft regardless of the citizenship or residence of either the employee or the employer if the employment contract is entered into in this country, or if the vessel or aircraft touches a U.S. port while the employee is employed on it.
•   If those taxes are provided for in a binational social security agreement.
An American employer is the U.S. government, an individual resident of the United States, a partnership of which at least two thirds of the partners are U.S. residents, a trust if all of its trustees are U.S. residents, or a U.S. corporation. A foreign affiliate of an American employer is any foreign entity in which an American employer has a direct or indirect 10% or greater interest (for a corporation the interest must be in voting stock; for any other entity the interest must be a profits interest). An American vessel is one documented or numbered under U.S. law, or if undocumented, one the crew of which is employed solely by one or more U.S. persons. An American aircraft on one that is registered under U.S. law.
American employers can extend social security coverage to U.S. citizens and residents who work abroad for an affiliated company. Form 2032 is used. Binational social security agreements, called totalization agreements, are in force between the United States and several foreign developed countries. They generally provide that social security taxes need be paid to only one country, usually that in which the employee works.149
149 See IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, and 917 T.M., International Aspects of the U.S. Social Security Tax.
4. Self-Employment Tax
U.S. citizens and resident aliens who are self-employed abroad are generally subject to U.S. self-employment tax. In some cases, a social security totalization agreement with the country in which the individual is self-employed may provide otherwise. In determining the amount of the tax, the taxpayer is required to take all foreign earned income into account whether or not he elects the earned income exclusion.150
150IRS Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
5. Employees of U.S. Government and Its Agencies 
The earned income exclusions are not available to an employee of the U.S. government or its agencies.151  In contrast amounts paid by the government or its agencies to a non-employee, such as an independent contractor, are available for the exclusions, assuming the regular tests are met. A considerable amount of litigation has centered around the questions of whether the taxpayer was indeed a tainted employee, and whether the employer was a U.S. government instrumentality.152
151§911(b)(1)(B)(ii).  See Eren v. Comr., 99-1 USTC ¶50,599 (4th Cir. 1999) (State Department  architect was employee, not independent contractor); but see Chin v. U.S.,  57 F.3d 722 (9th Cir. 1995) (Malaria specialist working for AID in Pakistan not an employee because specialist was not subject to AID's day-to-day control). The issue can also be whether the worker's employer is the United States or an agency thereof. Adair v. Comr., T.C. Memo 1995-493, acq, 1996-1 C.B. 1 (U.S. Army civilian program analyst transferred to NATO but still paid by the Army held to be employee of NATO and not a U.S. Army employee); CCA 199937041 (U.S. armed service members transferred to NATO are subject to continuing disciplinary and other controls by the U.S. military and therefore remain U.S. employees).
152Before the 1982 Act amended §911(b)(1)(B)(ii), the disqualification turned on whether the payment to the taxpayer was from the U.S. government or one of its instrumentalities. For example, the issue in Kalinski v. Comr., 64 T.C. 119 (1975), aff'd, 528 F.2d 969 (1st Cir. 1976), was whether income received by an employee of a child guidance center under the control of the U.S. military was received from the government. (Held: Yes.) Accordingly, care should be taken in using cases determined under prior law. Some retain vitality to the extent they consider whether the taxpayer was a government employee.
 Example (49)—U.S. Employees
Taxpayer worked in Germany as an employee of a nonappropriated fund organization that was associated with the U.S. Army recreation system. The organization was partially self-supporting, quasi-governmental, and provided services to military personnel in Germany. Taxpayer was paid exclusively from funds that were not appropriated by Congress. Because he was a U.S. government employee, his wages were not foreign earned income.153
153See Matthews v. Comr., 907 F.2d 1173 (D.C. Cir. 1990), aff'g 92 T.C. 351 (1989).
The Code gives some relief to civilian employees stationed abroad in the form of exemptions for certain allowances.154 
154§912.
¶7130.02.I. Illustrative Example
This comprehensive fact situation, created by the Service, illustrates some of the rules outlined above.
Jim and Judy Adams are married, with two dependent children.  They are both U.S. citizens and file a joint U.S. income tax return. They each have a tax home in a foreign country and both meet the physical presence test for all of 2001 and thus qualify to exclude their foreign earned income up to the applicable limits.
Jim is a petroleum engineer. He works primarily in the Persian Gulf region. For 2001, his salary, which was entirely from foreign sources, amounted to $71,000. In addition, his employer provided him an annual housing allowance of $18,000, which he used to maintain a rented apartment at his tax home in Country X for the period he was not working at remote drilling sites.
At various times during the year, Jim worked at remote sites, his employer provided him lodging and meals at nearby camps.  Satisfactory housing was not available on the open market near these drilling sites, and the lodging was provided in common areas that normally accommodated 10 or more employees and were not available to the general public. The fair market value of the lodging he was provided in these camps was $2,000 and the value of the meals was $1,000.
Jim was reimbursed by his employer, after he made an adequate accounting, for part of his travel expenses and other employee business expenses. In addition, Jim had $2,500 of unreimbursed employee business expenses for travel, meals, and lodging that were allocable to his foreign earned income.
Because of adverse conditions in Country X, Judy and the children lived in Paris, France, while Jim worked in the Middle East.  Judy had a job as an executive secretary with a U.S. company in Paris. Her earnings from this job were $44,000 in 2001. These earnings were subject to French income tax.
The Adams family rented an apartment in Paris during 2001 for Judy and the children. They paid $1,000 a month rent, including utilities, or $12,000 for the year. The Adamses choose to treat the expenses for the Paris apartment as those for a qualified second household, because conditions at Jim's tax home in Country X are considered to be adverse. They include the $12,000 Paris housing expenses with Jim's $18,000 Country X housing expenses and this results in a larger total housing exclusion.
Jim and Judy also had taxable U.S. interest and dividend income of $7,500 in 2001. The Adamses had no other income for the year and do not itemize deductions. The Adamses report their income, figure their foreign earned income exclusions and foreign housing exclusion, and figure their tax as follows.
First, they list their income on the front of Form 1040.  Their combined salaries, including Jim's $18,000 housing allowance, amount to  $133,000. They enter this on Form 1040 and their interest and dividend income  of $7,500 (including a list of payers and amounts) on Schedule  B (Form 1040).
At this point, they complete two Forms 2555 to figure their  foreign earned income and housing exclusions. On Jim's Form 2555,  Part III, he lists his salary, his housing allowance, and the fair market value  of meals and lodging provided in camps by his employer. This last item totalling  $3,000, is not shown as income on Form 1040. Jim subtracts it on  Form 2555.
Jim combines his housing expenses, $18,000, with the qualified expenses for the second household that he maintains for his wife and children, $12,000, and enters total housing expenses of $30,000. He puts a base amount of $10,557 on line 30 and subtracts that amount to arrive at a total foreign housing amount of $19,443. He then figures an exclusion of $19,443 (attributable to the amounts provided by his employer).
Note: Although Judy could claim a separate housing exclusion for the expenses of the Paris apartment, rather than combining those expenses with Jim's housing expenses, she does not do so because she would have to reduce her expenses by a separate base housing amount. Also, her foreign earned income is less than the $78,000 maximum foreign earned income exclusion, so claiming a separate housing exclusion would not result in any tax benefit.
Jim figures his foreign earned income exclusion on Form 2555.  Because his exclusion, $69,557 (Jim's $89,000 of foreign earned income minus  his $19,443 housing exclusion), is less than the maximum exclusion of  $78,000, Jim is entitled to exclude $69,557 for 1994.
When Jim combines the exclusion of $69,557 with his housing exclusion of $19,443, he comes up with a total exclusion of $89,000.
None of his unreimbursed employee business expenses are allowable because they are all allocable to excluded income. However, the Adamses are still entitled to the full standard deduction for a married couple filing jointly.
Judy completes a separate Form 2555-EZ to figure her foreign earned income exclusion. Her foreign earned income is well  below the maximum excludable amount ($78,000), and she excludes her entire $44,000 salary.
The Adamses enter their combined exclusions of $133,000 on Form 1040. They identify this item to the left of the entry space. Their adjusted gross income is $7,500 from their interest and dividend income, which does not qualify for exclusion.
After subtracting their standard deduction of $7,600 and $2,900 for each of their four exemptions, Jim and Judy arrive at a taxable income of zero on Form 1040. They owe no U.S. tax for the year.
¶7130.03
Foreign Tax Credit
U.S. persons who include foreign income in their U.S. tax base may be subject to foreign tax on that income. The foreign tax credit is one of the major devices with which the Code addresses that problem.
The foreign tax credit may be a direct credit, or an indirect or deemed credit. The direct foreign tax credit is allowed for foreign income taxes paid on income from direct operations or direct investments in a foreign country. The deemed credit is allowed for foreign income taxes paid by certain foreign subsidiary operations when their foreign earnings are paid as a dividend to a U.S. shareholder or are included in his income under Subpart F of the Code.
Limitation provisions generally restrict a taxpayer to a credit that is the lesser of:
•   the foreign income taxes paid or deemed paid, or
•   the pre-credit U.S. tax on the taxpayer's foreign source income, or
•   the pre-credit overall U.S. tax.
The rules for the determination and application of the foreign tax credit are discussed above in ¶7110.
¶7130.04
Tax Avoidance Foreign Corporations Owned by U.S. Persons
¶7130.04.A. Foreign Personal Holding Companies
1. Overview 
A foreign personal holding company (FPHC) is a foreign corporation that meets statutory tests for U.S. ownership and types of gross income. 155  Both tests must be satisfied in order for a corporation to be an FPHC for a  given taxable year. A foreign corporation can be an FPHC in one year, but not  in another, depending on whether the stock ownership and income tests are met. 
155§552(a). See  §§551-558.
The FPHC provisions cover some kinds of investment income that are also encompassed by other Code regimes. As a result, the Code establishes rules of precedence. If a foreign corporation's income could be taxed both  as Subpart F income and FPHC income, then it is taxed as the former. 156 And if  shareholders are subject to tax both under the FPHC and passive foreign  investment company provisions, the former prevails.157 Even if those  regimes are avoided, U.S. shareholders' foreign income may still be trapped  by the rules that apply to foreign investment companies, regular personal  holding companies, or the accumulated earnings tax.  
156§951(d).
157§551(g); see  §1293(g)(2). 
U.S. shareholders of an FPHC include in their gross income undistributed FPHCI to the extent it would have been a dividend if an actual distribution had been made.158 The U.S. shareholder is entitled to increase his basis in the corporation's stock in an amount equal to the notional dividend as if it had been put back into the corporation as a contribution to its capital.159  
158§551(a), (b).
159See  §551(e). 
A foreign corporation meets the stock ownership test if at any time during the taxable year five or fewer individual U.S. citizens or residents directly or indirectly own more than 50% of either the combined stock voting power or the total stock value of the corporation.160 The income test is met if at least 60% (50% in some cases) of the foreign corporation's gross income for the taxable year is "foreign personal holding company income."161  
160§552(a)(2).  
161§552(a)(1). 
In general, FPHCI includes dividends, interest, rents, royalties, annuities, certain securities and commodities gain, income from personal service contracts, and income received from shareholders for the use of corporate property.162 The source of the income is irrelevant for purposes of defining FPHCI. 163  
162§553.  
163§555(a). 
Undistributed FPHCI is the foreign corporation's taxable income, determined after making certain adjustments, minus the dividends paid deduction.164 The deduction for dividends paid includes the sum of dividends actually paid during the corporation's taxable year, and any consent dividends for the taxable year.165  
164§556.  
165§561. Consent dividends are described in  §565. The dividends paid deduction for a personal  holding company also includes dividend carryovers and certain dividends paid  during the following taxable year.  §§561(a)(3),  563. If a foreign corporation is both a (regular)  personal holding company and an FPHC, however, the FPHC rules take precedence,  and the regular personal holding company rules do not apply.  §542(c)(5). Thus, the additional aspects of  the dividends paid deduction keyed into regular personal holding companies do  not apply. 
Each U.S. shareholder of an FPHC who was a shareholder on the last day of the taxable year on which a U.S. shareholder group existed includes in his gross income as a dividend the amount he would have received as a dividend if the distribution had been made on that day.166 The amount  included in income is his share of the foreign corporation's undistributed  FPHCI.167  
166§551(a) and (b). for the definition of a U.S.  shareholder group, see ¶7130.04.A.3.a, below.  
167§551(b). 
2. Excepted Foreign Corporations 
A foreign corporation exempt from U.S. tax as a charitable or similar organization cannot be an FPHC.168 In addition, a  foreign corporation that is organized and does business under the banking  laws of a foreign country is not an FPHC if it was not formed or availed of  to avoid U.S tax on its shareholders. A bank which qualifies for the exception  must get a certificate to that effect from the IRS.169 The excluded bank's U.S. stockholders are required to file a copy of the certificate with their returns.170  
168§552(b)(1). 
169§552(b)(2). The regulations establish the  certification procedure. Regs. §1.552-4.
170§552(b). 
3. Stock Ownership Test 
a. In General 
A foreign corporation meets the stock ownership test for FPHC status if "at any time" during the taxable year more than 50% of the stock of the corporation is owned by five or fewer individuals who are U.S. citizens or resident aliens.171 The five or fewer  individuals are known as the U.S. shareholder group.172 There are several subsets to that test: 
•   Stock ownership can be direct, indirect, or constructive. 173  
•   All classes of stock are considered. 
•   The percentage test is based either on the value or the  voting power of the stock. 
•   Special rules apply to identify the taxable year. 174  
171§552(a)(2).  U.S. citizens include those resident abroad. 
172Id.
173§554(a). Indirect and constructive ownership are discussed in  ¶7130.04.A.3.c and d, respectively, below.  
174See §898(c)(1)(A) and  (c)(2). 
Because a foreign corporation can be an FPHC if it meets the stock ownership requirement at any time during the taxable year, it is necessary to consider any change in the ownership of its stock during the entire taxable year in determining its status.175 The stock ownership  test is met if 50% of the stock is owned by U.S. citizens or residents at any  time during the year, no matter how brief that period may be. 
175See Regs.  §1.552-3(b). 
b. Determining Value Owned 
The value of stock owned by a shareholder is determined in light of all circumstances.176 Value may be  determined on the basis of the company's net worth, its earning and dividend  paying capacity, the appreciation of its assets, and such other factors as  have a bearing on the value of the stock.177  
176Regs.  §1.552-3(c).  
177Id.
The Tax Court, in interpreting the "more than 50% in value of stock" requirement, has held that an arm's-length sale close in time to the valuation date is persuasive evidence of value, absent a showing that some event between the valuation date and the sale date caused such value to change.178  
178Mariani Frozen Foods, Inc. v. Comr.,  81 T.C. 448 (1983), aff'd on other issues sub. nom. Melinda L. Gee  Trust v. Comr., 761 F.2d 1410 (9th Cir. 1985) (per curiam). 
c. Indirect Ownership 
Indirect ownership of stock includes shares beneficially owned for the target taxpayer. Stock of a corporation owned by another corporation, partnership, estate or trust is considered owned proportionately by its stockholders, partners, or beneficiaries, respectively. 179  
179§554(a)(1), which  merely restates the definition of indirect ownership, including it as part of  the definition of constructive ownership as well. 
 Example (50)—Indirect Ownership
Individuals One and Two are each 50% beneficiaries of Trust, which in turn  owns all the stock of Corporation One, which in turn owns all the stock of  Corporation Two. The two individuals are treated as owning equally all of the  stock of both corporations.180  
180Regs.  §1.544-2. The regulations under  §544, which deals with stock ownership of  regular personal holding companies, apply to FPHCs. Regs.  §1.552-3, referencing Regs.  §1.544-2. 
Note: These indirect ownership rules apply in determining  whether a corporation is an FPHC. Other indirect ownership rules apply, once  FPHC status has been established, in determining the number of shares  considered to be owned by a person for purposes of taxing that person under  the FPHC rules.181  
181See ¶7130.04.A.7.a.(1).(b),  below. 
d. Constructive Ownership 
(1) General 
Three constructive ownership rules apply in determining whether a corporation is an FPHC. The same rules apply in determining whether income from personal service contracts and from the use of corporate property by a shareholder is FPHCI.182 They do not apply, however, in determining the percentage of the corporation's  stock owned by U.S. shareholders for purposes of including amounts in income,  which is governed by direct ownership and special indirect ownership rules. 183  
182§554(a).
183See ¶7130.04.A.7, below. 
(2) Statutory Attribution Scheme 
(a) Rule 1: Entity Attribution 
Stock owned directly or indirectly by or for a corporation, partnership, trust or estate is treated as owned proportionately by its shareholders, partners and beneficiaries.184 There are no rules that attribute stock owned by a  shareholder, partner, or beneficiary to an entity,185 since the concern of  the FPHC constructive ownership rules is to find individuals' holdings to  determine whether a U.S. group exists. 
184§554(a)(1). This rule is the same as the  indirect ownership rule. The difference in the context of the constructive  ownership rules is that it may be applied in conjunction with other  constructive ownership rules to create further attribution of stock ownership,  as discussed below. 
185Compare §318(a)(3). 
Stock owned by a corporation is attributed "proportionately" to each of its shareholders, regardless of how small the interest of a particular shareholder may be. However, the Code does not indicate how stock owned by a corporation is to be allocated "proportionately" among its shareholders. The indirect ownership rules of subpart F, however, also use the term "proportionately," without expressly providing the manner of determining the proportionate share.186 The regulations  under that provision provide that the purpose for which "proportionate" is  being defined determines how it is defined.187 For instance,  the regulations provide that, if "proportionate" is being defined to determine  whether the vote188 held by U.S. shareholders make a  foreign corporation a CFC, a person's proportionate interest would be  determined by his percentage of vote in the corporation.189  
186§958(a)(2).  
187Regs.  §1.958-1(c)(2).  
188 The regulations were written before the test  for CFC status was vote or value. 
189Regs.  §1.958-1(c)(2). 
Comment: Because of the similar statutory language and  purposes of the CFC provisions and the FPHC regime, the IRS would likely  apply a similar rationale to §554. That would  mean that for purposes of the value portion of the stock ownership test,  "proportionate" would be determined according to value, while for the vote  portion of the test, percentage of the vote would be telling. 
As in the case of attribution from corporations, there is no clear standard provided for determining how a partner's proportionate interest in a partnership is to be measured. In most cases, however, it matters little, since all the stock owned by a partnership is attributed to each individual partner through the combined operation of entity attribution and partner attribution, discussed below. 
However, stock owned by another partner is not attributed to a corporate partner. Therefore, a corporate partner's proportionate ownership in the partnership would be important in determining attribution of stock held by the partnership. For subpart F purposes, the regulations' definition of "proportionate" discussed above also applies to attribution from partnerships.  Therefore, the value of a partnership interest would presumably determine  proportionate ownership for the FPHC value test. Thus, differing rights to  profit, loss, and capital in a partnership interest would be taken together  in determining its value. 
Also unclear is how proportionate ownership would be determined under the FPHC vote test. Under the subpart F regulations,190 a partner's  percentage control over partnership actions (in essence, his vote) should  define "proportionate." That would mean looking at the partnership agreement  to determine how decisions are made. If partnership action must be made on  the basis of unanimous partner agreement, it would appear each partner has  equal control, regardless of varying interests in profit or other items. If  each partner has a weighted right to vote, based, for example, on some  percentage interest, that percentage would define "proportionate." 
190See Regs.  §1.958-1(c)(2) 
The owner of a "grantor trust" is allocated all the stock owned by the trust.191  
191Rev. Rul. 79-116, 1979-1 C.B. 213.  §554, however, does not specifically provide  this (compare §318(a)(2)(B)). Rev. Rul. 79-116 was obsoleted by Rev. Rul. 2003-99, 2003-34 I.R.B. 388. Thus action was presumably taken because the foreign entity in the ruling would no longer be treated as a trust for U.S. tax purposes. The basic principle of the ruling still stands.
 Example (51)—Constructive Ownership: Grantor Trust
Nonresident Alien is the grantor of a foreign trust. The trust owns all  the stock of a foreign corporation. Alien is treated as the owner of the  shares, and his U.S. citizen spouse is thereby considered to own them by  virtue of the family attribution rules, discussed below.192 If the corporation meets the income  test, it is an FPHC. 
192Rev. Rul.  79-116, 1979-1 C.B. 213. In the ruling, the alien  grantor established a German anstalt which the IRS classified as a grantor  trust rather than a corporation. 
With respect to nongrantor trusts, the Code does not specify how a beneficiary's proportionate interest is to be measured. The IRS ruled that the term "beneficiary" in the domestic  personal holding company context had the same meaning as in  §318, the regulations under which provide for  actuarial computation of percentage interests in the trust.193 
193Rev.  Rul. 71-353, 1971-2 C.B. 243. 
In 1943, however, the Tax Court, declared that, for purposes of the predecessor of §544(a)(1), "the word  `beneficiaries' means those who have a direct present interest in the shares  and income in the current taxable year and not those whose interest, whether  vested or contingent, will or may become effective at a later time." 194 This holding precluded computing the ownership  interests of beneficiaries of trusts on an actuarial basis. Steuben Securities  has not been overruled, but it has not been followed by other courts, either.  For example, the Fifth Circuit dismissed such a narrow interpretation of the  word "beneficiaries" for domestic personal holding company purposes. 195 The IRS followed Phinney, announcing that it would not follow this aspect of the Steuben Securities decision, and that shares held by a trust should be considered to be owned by its present and future beneficiaries in accordance with their actuarial interests.196 This ruling, and  Rev. Rul. 71-353, probably apply to FPHCs as well,  since the two statutes contain identical language and are designed for a  similar purpose. 
194Steuben Securities Corp. v. Comr., 1 T.C. 395, 399 (1943).  Compare §318(a)(2)(B), which provides for an  actuarial determination.
195Phinney v. Tuboscope Co., 268 F.2d 233 (5th Cir. 1959).  
196Rev. Rul.  62-155, 1962-2 C.B. 132. 
The most difficult cases concern the attribution of ownership to a discretionary class of beneficiaries. For example, a trust instrument may give the trustee absolute discretion to distribute income or corpus to any of several persons. It is difficult, if not impossible, to value the interest of such persons. The IRS has privately ruled for domestic personal holding company purposes that, in the case of a discretionary trust, the trustees' discretionary powers prevented actuarial valuation of the beneficiaries' interests. Therefore, the IRS used a facts and circumstances method to allocate ownership of the trust's stock. Specifically, the IRS ruled that each beneficiary is considered to own an income interest in the same proportion as the amount of distributions he typically receives bears to the total amount of distributions.197  
197PLR  9024076. 
It is unclear how the IRS would allocate stock ownership in the case of trust beneficiaries with a contingent future interest in principal at the discretion of the trustee. 
The situs or residence of a trust is immaterial in applying the trust attribution rule. 
Unlike trusts, attribution from estates appears to be on the basis of present direct interest only. "Beneficiary" is defined in that manner under the §318 regulations, 198 which, as noted above, probably apply in defining that term under  §554.199 Stock owned by an insolvent  estate, however, is considered owned by its creditors.200  
198Regs. §1.318-3(a).  
199See also Commercial  Finance Co. v. Comr., T.C. Memo 1968- 229 (dealing with domestic  personal holding company status).  
200Renton Investment Co. v. Comr., 131 F.2d 330 (3d Cir. 1942)  (dealing with domestic personal holding company status). 
The §318 regulations also provide that  stock owned by an estate is allocated proportionately even if the stock is  specifically bequeathed to someone.201 It is  unclear whether this rule would apply to FPHC attribution. 
201Regs.  §1.318-3(a), Ex. (2). 
(b) Rule 2: Family and Partnership Attribution 
Stock owned by an individual's family members and his partners is attributed to him. 
Stock owned directly or indirectly by or for an individual's spouse, sibling, ancestor,202 or lineal descendant is treated as owned by that individual.203 Attribution from  ancestors and descendants is not limited to a certain number of generations. 204 Thus, stock owned by an individual's great-grandfather may be attributed to him, and vice versa. 
202The term "ancestors" does not include aunts  and uncles. Rev. Rul. 59-43, 1959-1 C.B. 146.
203§554(a)(2).  
204Compare §318(a)(1). 
There is no express limitation on attribution between spouses who are legally separated by a decree of separate maintenance.205 Also, there is no specific provision governing attribution  to and from a legally adopted child.206  
205Compare  §318(a)(1)(A)(i). But of course there  would be no attribution from a "spouse" if none existed under the applicable  local law.  
206Compare §318(a)(1)(B). 
Under a special rule, stock owned by a nonresident alien individual (other than a foreign trust or foreign estate) is not attributed to his or her U.S. citizen or resident alien family member if the family member: (1) is not the spouse of the nonresident alien and (2) the family member does not otherwise own stock in the corporation (after application of the constructive ownership rules other than family attribution).207  
207§554(c)(1). 
Stock owned by an individual's partner is treated as owned by that individual.208 Under a special rule, however, stock owned by a nonresident alien individual  (other than a foreign trust or foreign estate) is not attributed to that  foreign person's U.S. citizen or resident partner if the partner does not  otherwise own stock of the corporation (after application of the constructive  ownership rules other than partner attribution).209  
208§554(a)(2). 
209§554(c)(2). 
The partner attribution rule should not be confused with the rule governing attribution from a partnership proportionately to the partners, discussed in ¶7130.04.A.3.d.(2).(a), above. 
(c) Rule 3: Options 
Any person with an option to purchase stock is treated as owning that stock.210 An option to acquire an option to purchase stock, or any series of such  options, is also treated as ownership of the stock.211  
210§554(a)(3).  
211Id. See  Rev. Rul. 82-150, 1982-2 C.B. 110. 
(d) Interaction of Rules 1 Through 3 
In applying the above rules, rules (1) (entity attribution) and (3) (option attribution) are applied repeatedly, so that stock considered owned by a person through entity attribution or option ownership can be treated as owned by another person under rules (1) or (2) (family and partner attribution).212 On the other hand, stock considered owned by an individual because a family  member or partner owns the stock (rule (2)) cannot be further attributed to  another person.213 Therefore, stock held by entities is  attributed up through each level of entity ownership, until it reaches the  individual level; then, it is attributed just once more to that individual's  family members and partners. If it were further attributed to those individuals'  family members and partners, the whole world might eventually be considered to  own the stock.
212§554(a)(5).
213Id. 
If stock may be considered owned under either rule (2) (from a family  member or partner) or rule (3) (option attribution), it is considered to be  owned under rule (3), so that further attribution will apply.214  
214§554(a)(6). 
(e) Convertible Securities 
Outstanding securities of a corporation convertible into stock are treated as outstanding stock for purposes of the constructive ownership rules, even if not convertible in the relevant tax year, if the effect of including them is to make the corporation an FPHC.215 A corporation with  convertible securities must be tested for FPHC status (1) by considering none  of the convertible securities to be stock, (2) by considering all the  convertible securities to be stock, and (3) if groups of securities are  convertible at different times, by considering each group of convertible  securities as stock as it becomes convertible, along with the groups that  become convertible before it.216 The  corporation passes the FPHC ownership requirement if the requisite ownership  is found under any of the above scenarios. 
215§554(b)(1).  
216See §554(b) (flush language). 
(3) Nonresident Aliens Becoming U.S. Residents 
A foreign corporation that is not an FPHC can change to that status if a nonresident alien shareholder becomes a resident of the United States. Thus, shareholders of foreign corporations who become residents of the United States may become subject to the FPHC rules upon the establishment of residency and may thereby expose minority U.S. shareholders to the same rules. 
4. Gross Income Test 
a. Threshold Percentage 
If a corporation has not been an FPHC for any tax year beginning after August 26, 1937, the threshold for determining whether it has sufficient FPHCI is 60% or more.217 Once a corporation  has qualified as a foreign personal holding  company in any tax year, however,  the threshold for subsequent tax years drops to 50% or more, unless (1) one  tax year has intervened in which the ownership requirements are not met or  (2) three consecutive tax years have intervened in each of which less than  50% of the gross income of the corporation is FPHCI.218 If one of these tests  is satisfied, the threshold returns to 60%. 
217§552(a)(1).  
218§552(a)(1); Regs.  §1.552-1(a). 
b. Definition of "Gross Income" 
The gross income determination is based on a special definition applicable to FPHCs. Gross income for this purpose is not synonymous with gross receipts.219 Moreover, gross income takes into account additions to gross income which  result from the corporation's ownership of stock in another FPHC. 220 Thus, the gross income test may be  satisfied when the corporation's actual FPHCI receipts are less than 60%  (or 50%) of gross income. 
219§555; Regs.  §1.552-2(b);  Woodside Acres, Inc. v. Comr., 134 F.2d 793 (2d Cir. 1943).
220§555(b). See ¶7130.04.A.4.b.(6), below. 
(1) General 
Gross income is defined for FPHC purposes as the gross income of the corporation as if it were a domestic personal holding company.221 Income for FPHC  purposes is included without reference to its source and, therefore, includes  all domestic as well as foreign source income, even if the corporation does  not engage in a U.S. trade or business.222 Since an FPHC's gross  income is determined on a worldwide basis, the allocation of expenses to U.S.  or foreign source income is irrelevant. 
221§555(a). See §542(a)(1) and Regs.  §1.542-2 regarding the computation of the  gross income of a domestic personal holding company.
222§555(a) (parenthetical); Regs.  §1.555-1. 
Generally, manufacturing, merchandising and mining businesses calculate their gross income by subtracting from their gross receipts the cost of goods sold.223 Accordingly, a  taxpayer cannot inflate a foreign corporation's gross income by having the  corporation engage in the purchase and sale of goods at low or negligible  profit margins. Service businesses, on the other hand, use gross receipts as  their gross income.224 In the case of transactions in stocks and/or securities and in commodities, gross income for purposes of the domestic personal holding company tax includes only the excess of gains over losses from such transactions. 225  
223See Regs.  §1.61-3(a). 
224Andrews Jergens Co. v. Comr.,  40 BTA 868 (1939). For a more complete discussion of "gross income," as  defined for domestic personal holding company purposes, see 797 T.M., Personal Holding Companies.  
225§553(b). 
Since an FPHC computes its gross income as if it were a domestic personal holding company, it may make the same type of elections a domestic corporation can make in reporting its income.226  
226See, e.g.,  Rev. Rul. 76-44, 1976-1 C.B. 127. 
(2) Tax-Exempt Bond Income 
An FPHC's gross income does not include interest on governmental obligations that is excluded from gross income.227  
227Rev. Rul.  72-527, 1972-2 C.B. 456. 
(3) Income Exempted by Tax Treaty 
The gross income of an FPHC is computed as if the corporation were a domestic personal holding company.228 Since the latter would not  be entitled to treaty benefits, income that is exempt from U.S. tax under a  tax treaty is nevertheless includible in the FPHC's "gross income." This rule  appears not to violate U.S. treaty obligations since the FPHC provisions tax  the U.S. shareholders and not the foreign corporations. 
228§555(a). 
(4) Dividends Attributable to Pre-Taxed Income 
Excluded from the gross income of an FPHC are dividends it receives that are excluded from income because they are attributable to previously taxed income.229 This rule  alleviates the possibility of double taxation when the FPHC receives a  dividend out of earnings that have already been taxed under the CFC rules. 
229Regs. §1.555-1.  See §959(b). 
(5) Related Party Dividends and Interest 
Gross income includes dividends and interest paid by a related non-FPHC, 230 though some portion or all may be excluded from FPHCI.231  
230§552(c) (flush language).  
231See ¶7130.04.A.5.a, below. 
(6) Income of Lower-Tier Foreign Personal Holding Company 
A foreign corporation that is a shareholder in an FPHC must include in its gross income, as a dividend, the amount that it would have received if a distribution had been made on the last day of the taxable year on which it met the stock ownership requirement for FPHC status. 
This rule is applied in determining (1) whether the first company meets the gross income requirement for FPHC status, and (2) the amount of undistributed FPHCI of the first FPHC that is includible in the gross income of its U.S. shareholders.232 The assumed  dividend is included in the income of the first corporation in the year in  which or with which the taxable year of the second company ends. 233  
232Regs.  §1.555-2(a)(2).
233Regs. §1.555-2(a)(2)(ii).  This assumes that the second foreign corporation meets the FPHC gross income  test. 
If an FPHC is a shareholder in another FPHC for the entire taxable year of the second company, the amount to be included in the first FPHC's gross income is its share of the undistributed FPHCI of the second FPHC for the latter's entire taxable year.234 If the  first FPHC is a shareholder for only a portion of the second FPHC's taxable  year, the amount to be included in its gross income is its share of the  undistributed FPHCI of the second FPHC computed for that portion of the  taxable year of the latter during which the first corporation is a shareholder. 235  
234Regs.  §1.555-2(a)(2)(ii). 
235Id. But see the discussion of the  Marsman case at ¶7130.04.A.7.b.(3), below. 
The amounts includible in gross income under this provision are required to be included "as a dividend." Because of such dividend treatment, if a lower-tier subsidiary foreign corporation's undistributed FPHCI is deemed distributed up through a chain of FPHCs to an upper-tier FPHC which, even after the constructive distribution, has a deficit in E&P, no part of the lower-tier subsidiary's income should be includible in the gross income of U.S. shareholders. 
5. Items of Foreign Personal Holding Company Income 
The key to the application of the FPHC provisions is the determination of a foreign corporation's FPHCI. The gross income test described above is satisfied only when 60% (or 50%) of a foreign corporation's gross income consists of FPHCI. 
FPHCI consists of that portion of gross income, whether foreign or U.S. source, which consists of: dividends; interest; most royalties; annuities; nondealer stock and securities gains; nondealer commodities gains; income from trusts and estates; and gain from the sale or exchange of an interest in a trust or estate; amounts received from personal service contracts; amounts received from certain use of corporate property; and rents.236 The regulations defining  FPHCI incorporate the definition of "personal holding company income" in the  domestic personal holding company regulations.237 A few exceptions are  carved out, though, with respect to certain interest and royalties, which are  discussed below. 
236§553(a).
237Regs.  §1.553-1. 
There are virtually no cases or rulings concerning the various categories of FPHCI. Most of the relevant authorities concern the domestic personal holding company definitions. The following summarizes the categories of FPHCI, which are taken into account for purposes of the gross income test. See 797 T.M., Personal Holding Companies,  for a more detailed discussion. 
a. Dividends, Interest, Royalties, and Annuities 
(1) Dividends 
The term "dividends" includes dividends as defined in  §316,238 under which a  distribution is not a dividend unless it is paid out of the distributing  corporation's current or accumulated E&P. Additions to gross income under  §555(b) are included in the term "dividend." 239 Thus, income of a foreign corporation that is derived from a deemed dividend  from a lower-tier FPHC constitutes FPHCI. 
238Regs.  §1.543-1(b)(1). 
239Regs.  §1.552-2(a). 
(2) Interest 
"Interest" generally means any amount includible in gross income that was received for the use of money loaned. 240 Interest includes original issue discount.241 Interest income also includes  interest on promissory notes, mortgages (whether secured by real or personal  property), bonds, legacies, and life insurance. Interest includes usurious  interest (unless converted to principal under the relevant state law) and  loan fees that are in substance payments of interest.242 Tax-exempt interest is also specifically included in FPHCI for subpart F purposes and therefore, presumably, for FPHC purposes as well.243 The entire amount  received as interest is treated as interest whether or not it is treated as  "rent" for purposes of the domestic personal holding company rules. 244  
240Regs. §1.543-1(b)(2).
241PLR  8432019.  
242Regs.  §1.61-7;  see Western Credit Co. v. Comr., 38 T.C. 979 (1962),  aff'd per curiam, 325 F.2d 1022 (9th Cir. 1963).  
243See Regs. §§1.952-2(c)(1), 1.954-2(a)(4)(i), and 1.954-2(b)(3), all of which are effective for taxable years of a controlled foreign corporation beginning after March 3, 1997, changing the rule previously in effect on the basis that the exempt character at the corporate level does not apply at the shareholder level.
244Regs. §1.553-1(a). 
Interest for FPHCI purposes also includes "related-party factoring income."  Factoring income is the discount, stated interest, or similar income, from  acquired trade or service receivables.245  
245§864(d). 
Gross interest income is not reduced by interest expenses. Accordingly, the "net" interest income of the corporation does not govern for purposes of the gross income test.246  
246See Sieh v. Comr., 56 T.C.  1386 (1971), aff'd, 73-1 USTC ¶9281 (9th Cir. 1973).
(3) Look-Through Rules for Certain Interest and Dividends 
Interest and dividends received by a foreign corporation from certain same-country, related parties are FPHCI only to the extent they are attributable to income that would be FPHCI in the hands of the related payor. 247  
247§552(c)(1). 
For interest or dividends to qualify for the look-through rules, the payor must be: (1) a corporation248 that is organized in the same country as the payee and that has a substantial  part of its assets used in its trade or business located in the same country; 249 and (2) a  "related person" that is not an FPHC (tested without applying the interest and  dividend look-through exception).250  
248To the extent provided in regulations,  payments from partnerships with at least one corporate partner may be considered  made from the corporate partners in proportion to their percentage ownership.  §§552(c)(2)(A);  954(c)(3)(A) (flush language).  
249§§552(c)(2)(A);  954(c)(3)(A)(i). For subpart F purposes, §954(c)(3)(C) requires a qualifying dividend to be paid from earnings accumulated during the periods the paying corporation was directly or indirectly owned by the dividend recipient. See PLR 199907022 (Source of dividend for this purpose is most recently accumulated earnings and profits). 
250§552(c)(2)(B). 
A "related person" for purposes of the look-through rules is a corporation that: (1) controls the foreign corporation; (2) is controlled by it; or (3) is controlled by "the same person or persons" who also control the foreign corporation.251 "Control" means direct  or indirect ownership of more than 50% of the total voting power of all  classes of stock entitled to vote or of the total value of all stock. 252 Constructive ownership  rules "similar to" those of §958 apply. 253  
251§§552(c)(2);  954(c)(3).  
252§§552(a)(2);  954(d)(3).  
253§§552(c)(2);  954(d)(3). 
(4) Royalties 
Royalties include amounts received for the privilege of using patents,  copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other like property.254 The term  includes mineral, oil and gas royalties, and copyright royalties, which are  excluded from domestic personal holding company royalty income.255  
254Regs.  §1.543-1(b)(3). 
255Regs. §1.553-1(b). 
FPHCI, however, does not include royalties received by a foreign corporation in connection with the licensing of computer software, provided the following four tests are satisfied: 
(1) The foreign corporation must be engaged in the active conduct of a trade or business of developing, manufacturing or processing computer software; 
(2) The software royalties must constitute at least 50% of the foreign corporation's ordinary gross income for the taxable year; 
(3) Deductions allowed under §§162,  174, and 195 that are properly allocable to the software trade or business must equal or exceed 25% of the foreign corporation's ordinary gross income for the taxable year; and 
(4) The sum of dividends paid, dividends deemed paid, and consent dividends must equal or exceed the amount by which FPHCI exceeds 10% of ordinary gross income of the corporation for the taxable year. 256  
256§553(a)(1);  §543(d). 
A certain amount of confusion may arise as to whether an amount constitutes  "rents" rather than "royalties."257 This question is  significant because, if the "rents" received by an FPHC exceed 50% of the  corporation's gross income, none of the rents constitute FPHCI. The question  of whether a payment is rent or a royalty often arises in connection with  payments received for the use or exhibition of films, tapes, record masters,  and the like. In the domestic PHC context, amounts received for film use are  treated as rent only to the extent the film was acquired by the payee before  its substantial completion, or to the extent of the payee's participation in  production of the film.258 The remainder is  treated as copyright royalties. It is unclear whether this rule applies to  the FPHC definitions. 
257See Rev. Rul.  70-153, 1970-1 C.B. 139.  
258§543(a)(5). 
Amounts received for the "sale" of copyrights and other similar rights are not royalties.259 Whether a transfer of such intangible  property constitutes a sale rather than a license generally turns on whether  exclusive rights to exploit the property throughout its life have been  transferred. If exclusive rights have been transferred, the amounts received  do not constitute FPHCI even if the consideration is measured by the receipts  from the sale, performance, exhibition, or publication of a copyrighted work. 260  
259See Dairy Queen of Oklahoma, Inc. v. Comr.,  250 F.2d 503 (10th Cir. 1957).  
260Rev. Rul. 60-226, 1960-1 C.B. 26. 
In Rev. Rul. 75-202,261 an author transferred a copyright to a domestic  personal holding company and entered into a 15-year employment contract with  the corporation to write, edit, and compile future works. The corporation  then sold all of its rights to the work for the full copyright term to an  unrelated party for a lump sum plus a percentage of sales. The rights would  revert to the corporation in the event that they were not properly exploited.  The IRS ruled that the amounts received were for the sale of copyrights and  were not royalties for domestic or FPHC purposes. 
2611975-1 C.B. 170. 
(5) Annuities 
"Annuities" include amounts received as annuities only to the extent that they are includible in the computation of gross income.262 Under  §72, a portion of each annuity payment may be  treated as a return of capital which is not includible in gross income. 
262Regs.  §1.543-1(b)(4)  
b. Stock and Securities Transactions 
Gains from the sale of stock or securities are included in FPHCI (except in the case of regular securities dealers), but gross income and FPHCI include only the excess of total gains over total losses for the year from such transactions.263 Such  gains include gains from liquidating distributions and other distributions  from capital.264 The excess of  losses over gains from such transactions cannot be used to offset other FPHCI  and are not included in computation of "gross income." 
263§553(a)(2),  (b)(1); Regs. §1.543-2(a).
264Regs.  §§1.553-1,  1.543-1(b)(5). 
The term "regular dealer in stock or securities" means a corporation with an established place of business regularly engaged in the purchase of stock and securities and their resale to customers.265 However, such  corporations are not considered as regular dealers with respect to stock or  securities which are held for investment.266
265Regs.  §§1.553-1,  1.543-1(b)(5).
266See §1236 (definition of "held for investment" by  dealer). 
Income from sale of the stock of a subsidiary is FPHCI, and frequent sales of such subsidiary stock have been held not make a corporation a dealer in securities.267 FPHCI would include gain realized from the liquidation  of a subsidiary only if such gain would be recognized under the Code if the foreign  corporation was a taxable domestic corporation.268  
267U.S. v. Ross, 368 F.2d 455  (2d Cir. 1966).  
268Regs.  §1.952-2(c)(3); PLR  8029071. 
c. Commodity Transactions 
Gains from the sale of futures in any commodity on or subject to the rules of a board of trade or commodity exchange269 are included in FPHCI, but  gross income and FPHCI include only the excess of total gains over total  losses for the year from such transactions.270 In determining  such excess, all speculative gains and losses are excluded. Excess of losses  over gains from commodities transactions (except bona fide hedges) cannot be  used to offset other FPHCI and are not included in computing gross income. 271  
269See GCM  39725 (Apr. 15, 1988), revoking GCM  39191 (May 13, 1983) (privately negotiated spot  purchases of, and forward contracts for, commodities not treated as FPHCI  because they were not "effected on or subject to the rules of a board of  trade or commodity exchange;" however, gains from such transactions might  constitute interest for FPHC purposes).
270§553(a)(3), (b)(2). 
271Regs. §§1.553-1;  1.543-2(a), (b) Ex. (2). 
FPHCI, however, does not include such gains received by a producer, processor, merchant, or handler of the commodity in a bona fide hedging transaction reasonably necessary to the conduct of its business in the manner in which such business is customarily and usually conducted by others. 272  
272§553(a)(3); Regs.  §1.543-1(b)(6).
d. Estates and Trusts 
Amounts includible in computing taxable income under  §§641 through 683 (taxation of estates, trusts, and beneficiaries)  and gains from the sale or other disposition of an interest in an estate or  trust are FPHCI.273 Thus, distributions received from a trust or estate will be treated as  FPHCI regardless of the character of the income earned by the trust or estate making redistribution.274  
273§553(a)(4).  
274See §§661(b) and  662(b). 
e. Personal Service Contracts 
Income received by a corporation under a contract (written or oral) for the corporation to provide personal services is FPHCI if: 
(1) Some person other than the corporation has the right to designate the individual who is to perform the services, or if the individual is designated by the contract;275 and 
275§553(a)(5)(A).
(2) The individual designated or who may be designated under the contract owns 25% or more in value of the outstanding stock of the corporation at any time during the tax year in which the income is received.276 Direct, indirect, and constructive ownership rules apply in determining ownership of the stock.277  
276§553(a)(5); Regs.  §§1.553-1,  1.543-1(b)(8).  
277§§553(a)(5),  554(a). See ¶7130.04.A.3.c  and d, above. 
If, however, the contract requires the performance of services that are important and essential (not just incidental to the services to be performed by the designated individual) by or for a person other than a 25% owner, only the portion of the contract price attributable to the personal services of the 25% owner is FPHCI.278  
278Regs.  §§1.553-1,  1.543-1(b)(8)(ii);  see Allen Machinery Corp. v. Comr., 31 T.C. 441 (1958), acq.,  1959-1 C.B. 3 (discussion of what services are incidental). 
In addition to income received under a personal service contract being FPHCI, any gain from the sale or other disposition of such a contract is FPHCI.279  
279§553(a)(5)(B). 
 Example (52)—Entertainer's Personal Services
A, whose profession is that of an actor, owns all of the outstanding  capital stock of M Corp. M Corp entered into a contract with A under which A  was to perform personal services for the person or persons whom M Corp might  designated, in consideration of which A was to receive $10,000 a year from M  Corp. M Corp entered into a contract with O Corp which A was designated to  perform services for O Corp in consideration of which O Corp was to pay M  Corp $500,000 a year. The $500,000 received by M Corp from O Corp constitutes  personal holding company income (and, therefore, FPHCI).280 
280Regs.  §1.543-1(b)(8)(iii), Ex. (1) 
The IRS has ruled that a corporation is not in receipt of personal service contract income even when the services are performed by a sole shareholder-employee, so long as the clients of the corporation do not have the contractual right to the specific personal services of the shareholder-employee and the services involved are not so unique as to preclude substitution.281 In each case, the IRS ruled that the income in  question did not constitute personal service contract income. 
281See, e.g., PLRs  8237109 and  8234077 (attorney services); Rev. Rul.  75-67, 1975-1 C.B. 169 (services of a physician);  Rev. Rul. 75-249 1975-1 C.B. 171 (services of a  songwriter); and Rev. Rul. 75-250, 1975-1 C.B. 172  (accounting services). 
 Example (53)—Sole Shareholder-Employee
A, a U.S. citizen, is a certified public accountant. He owns all of the  shares of X Co., a Panamanian corporation. X Co. maintains an office in  London, England. A is employed by X Co. under a long-term employment contract.  X Co. employs two junior accountants. X Co.'s clients  deal with X Co. and do  not specifically request the services of any X Co. employee. All of A's services  and the services of the other two accountants are performed outside the United  States. On the basis of the foregoing rulings, X Co.'s income does not  constitute FPHCI and A is not taxed on the income until it is received as  salary payments or dividend distributions. 
The foregoing rulings do not protect personal service corporations from attack by the IRS under §482 282 and,  possibly, under §269A,283 or if the corporation is a sham,284 or an  agent of the shareholder. In addition, the IRS raised the issue of whether a  person is acting as an employee of a foreign corporation rather than as an  independent contractor.285 While this  argument principally concerns whether a foreign corporate employer can claim  the benefits of a tax treaty with the United States, the effect of disregarding  the employer-employee relationship of a U.S. employee-shareholder of a foreign  corporation is to subject that person to tax on the income attributed to the  corporation.286  
282Regs. §1.543-1(b)(8)(ii);  see Borge v. Comr., T.C. Memo 1967-173, aff'd,  405 F.2d 673 (2d Cir. 1968), cert. denied, 395 U.S. 933 (1969).
283§269A does not apply to a corporation that  does not perform substantially all its services for one other entity.
284Laughton v. Comr.,  113 F.2d 103 (9th Cir. 1940); Patterson v. Comr., 25 T.C.M. 1230  (1966), aff'd, 68-2 USTC ¶9471 (2d Cir. 1968).
285Rev. Rul.  74-330, 1974-2 C.B. 278; Rev. Rul.  74-331, 1974-2 C.B. 282.  
286The use of a corporation for personal services is  also subject to attack by the IRS under assignment of income principles.  See Lucas v. Earl, 281 U.S. 111 (1930); Rubin v. Comr.,  56 T.C. 1155 (1971), acq., 1972-1 C.B. 2, aff'd,  460 F.2d 1216 (2d Cir. 1972). 
f. Use of Corporation Property by Shareholders 
FPHCI includes amounts received as compensation (however designated and from whomever received) for the use of, or right to use, property of the corporation if, at any time during the taxable year, 25% or more in the value of the outstanding stock of the corporation is owned by or for an individual entitled to use the property.287 Direct, indirect, and constructive ownership rules  apply in determining ownership of the stock.288 Arrangements under which a 25%  owner in fact acquires such rights, such as lease of the property by the  corporation to a person who subleases it to the owner, are treated as giving  rise to FPHCI as well.289  
287§553(a)(6). The section is not limited to  nonbusiness property, although the principal abuses concerned the leasing of  yachts and residences. See Fourth and Railroad Realty Co. v. Comr.,  25 T.C. 458 (1955). 
288§§553(a)(6),  554(a).
289§553(a)(6); see Regs.  §1.543-1(b)(9). It has been held that  rental income received from a lessee corporation whose shareholders are  identical with those of the lessor corporation constitutes an "other  arrangement," rendering such income FPHCI, even though the corporation, not  "an individual," was ostensibly entitled to use the property.  320 East 47th Street Corp. v. Comr., 243 F.2d 894 (2d Cir. 1949).  Contra Minnesota Mortuaries, Inc. v. Comr., 4 T.C. 280 (1944). 
FPHCI includes compensation for use of property, however, only for a corporation that has other FPHCI (not including rent) that is more than 10% of its gross income.290  
290§553(a)(6). 
g. Rents 
Rents are included in FPHCI unless rent received by the corporation constitutes 50% or more of the gross income of the corporation. 291 "Rent"  means all compensation for use of, or the right to use, property, but not  amounts qualifying as FPHCI under the rule dealing with shareholder use of  corporate property.292  
291§553(a)(7). 
292Id.
Rent does not include compensation for use of intangible property, which is covered the rule for royalties.293 Rental income, however,  includes all other forms of compensation for the use of or right to use real  or personal tangible property, whether or not derived from an active rental  business. 
293See Montgomery  Coca-Cola Bottling Co. v. U.S., 706 Ct. Cl. 864 (1975) (dealing with  domestic personal holding company income). 
6. Undistributed Foreign Personal Holding Company Income 
a. Taxable Income Minus Dividends Paid 
Despite its name, undistributed FPHCI is not limited to FPHCI; it includes all of the FPHC's taxable income, with a few adjustments, minus dividends paid.294 For this  reason, an FPHC should not be used to operate a profitable active business,  since the income from that activity is taxed, along with FPHCI, as a dividend. 
294§556(a). 
Undistributed FPHCI included in the gross income of an FPHC from stock it holds in another FPHC is also considered part of its undistributed FPHCI. 295  
295§555(c)(1). 
b. Adjustments to Taxable Income 
(1) Taxes 
Taxable income of the FPHC is reduced by accrued U.S. federal income and excess profits taxes, foreign and U.S. possession income, war profits, and excess profits taxes, to the extent a deduction is not otherwise provided for such taxes.296 There is no  deduction, however, for the accumulated earnings tax or the domestic personal  holding company tax.297 Also, the deductions  provided in §164(e), relating to taxes of a shareholder paid by the corporation, and §404,  relating to contributions to pension plans, are not allowed.298  
296§556(b)(1). No special deduction for  foreign taxes is necessary since such a deduction is available in calculating  "taxable income." The foreign tax credit, however, may not be claimed by the  corporation, but only by its shareholders. Regs.  §1.556-2(a)(3). 
297§556(b)(1).  
298§556(b)(6). 
The deduction is for taxes accrued in the taxable year, even if the corporation is a cash method corporation. 
(2) Charitable Contributions 
The deduction for charitable contributions is allowed subject to individual, rather than corporate, limitations. Also, no excess contribution carryovers from prior years are permitted. The "adjusted gross income" of the FPHC, necessary in computing the individual limitation, is its taxable income, computed as required under the corporate charitable contribution provisions, but not including the deductions for: (1) trade or business expenses and depreciation applicable to property, discussed below; or (2) contributions to pension plans, and not including in gross income any part of the undistributed income of another FPHC.299  
299§556(b)(2). 
(3) Dividends-Received and Other Special Corporate Deductions 
The special corporate deductions provided in  §§241 through 247  for dividends received and dividends paid are disallowed in computing undistributed FPHCI. The §248 deduction for  organizational expenses, however, is allowed.300  
300§556(b)(3). 
(4) Net Operating Losses 
The net operating loss of an FPHC may not be carried back and may be  carried over only one year. It is computed under  §172(c) without the special corporate  deductions of §§241 through 247.301   
301  §556(b)(4). 
(5) Expenses and Depreciation of Property
The total deductions, from trade or business expenses and depreciation, allocable to operation and maintenance of property by an FPHC may not exceed the rent or other compensation received for the use, or right to use, the property, unless it is established to the IRS' satisfaction that:
(1) The rent or other compensation received was the highest obtainable, or, if none was received, that none was obtainable;302
302§556(b)(5)(A).
(2) The property was held in the course of a bona fide business carried on for profit;303 and
303§556(b)(5)(B). This requirement contemplates not only active operations, but also a reasonable period for purposes of liquidation. Dwinnell & Co. v. Comr., 33 T.C. 827 (1960). 
(3) Either there was a reasonable expectation of profit from operation of the property or the property was necessary to the conduct of business.304
304§556(b)(5)(C). 
A U.S. shareholder must attach a statement to his return if his share of undistributed FPHCI is calculated by allowing the FPHC to take deductions that exceed income from the property. The taxpayer has the burden of proving compliance with the above three requirements.305  
305 Regs. §§1.556-2(e)(2), -2T(e)(2), (3). For taxable years beginning before 2003, the taxpayer must attach as part of the statement a copy of the contract, lease or rental agreement. For taxable years beginning after 2002, the contract, lease or rental agreement is not required to be submitted, but the taxpayer must retain such for his records.
c. Computation of Undistributed Foreign Personal Holding Company Income 
The following example illustrates the application of the rules for computing undistributed FPHCI. 
 Example (54)—Undistributed FPHCI
(a) The following facts exist with respect to M Corp, an FPHC: 
(1) The gross income of M Corp as defined in §555 is $300,000, of which $85,000 represents  its share of the undistributed FPHCI of another FPHC in which it is a shareholder;  $200,000 consists of dividends; $10,000 consists of fully taxable interest; and the remaining $5,000 consists of rent received from M Corp's principal shareholder for the use of property owned by M Corp. 
(2) M Corp's expenses are $85,000, of which $75,000 is allocable to the maintenance and operation of the property used by the principal shareholder, and $10,000 consists of office expenses allowable as a deduction. The claim for deduction for the expenses of, and depreciation on, the rented property in excess of the rent received for its use is not established as provided in §556(b)(5). The yearly depreciation  on the rented property amounts to $30,000. 
(3) Federal income tax withheld on M Corp's income from sources within the United States amounts to $59,125. 
(4) No gain from the sale or exchange of stock or securities is realized during the taxable year, but losses in the amount of $10,000 are sustained from the sale of stock or securities which constituted capital assets. Such losses are not allowed as a deduction in any amount.306  
306See §1211(a). 
(5) Charitable contributions amount to $15,000, of which $5,000 is deductible in computing taxable income under  §63. 
(6) Dividends paid by M Corp to its shareholders during the taxable year amount to $50,000. 
(b) M Corp's taxable income (including the distributive share of the undistributed FPHCI of the other FPHC) is $180,000, computed as follows (assuming for the purposes of this example only that the expenses of, and depreciation on, the rental property are properly deductible): 
                         Income Section 61
Dividends............................... $200,000           
Interest.................................. 10,000           
Rent....................................... 5,000                            
                                            -----            
Gross income as defined in §61........$215,000                                                    
                                         ======== 
Add: 
Distributive share of undistributed 
income of the other FPHC (considered as 
a dividend)............................... 85,000                                                    
                                           ------            
Gross income as defined in §555.......$300,000     
                                         ======== 
                         
                         Deductions §161 
Expenses allocable to operation of the       
rented property...........................$75,000 
Depreciation of the rented property.......$30,000 
Ordinary and necessary expenses (office)...10,000 
Contributions (within the 5% limitation      
specified in §170(b)(2)..................5,000 
                                            -----                                     
                                         $120,000                                                    
                                         ======== 
Taxable income for purposes of computing       
undistributed FPHCI......................$180,000 

     (c) M Corp's undistributed FPHCI is $160,875, computed as follows: 
                               Income 
Taxable income for purposes of computing      
undistributed FPHCI.......................$180,000                                    
                                          ======== 
Add (see §556(b)): 
     Contributions deductible in computing      
     taxable income under §63............$5,000      
Excess property expenses and depreciation      
over amount of rent received for use of      
property ($105,000-$5,000).................100,000            
Total Additions...........................$105,000                                  
                                           ======== 
                             Deductions 
Subtract (see §556(b)): 
     Federal income taxes...................$59,125     
     Contributions (within the percentage 
     limitations specified in 
     §170(b)(1)(A) and      
     (B), determined under §556(b)(2).....15,000             
            Total subtractions..............$74,125          
                                            ======= 
Net additions to taxable income under     
§556(b)..................................$30,875                   
                                            ------- 
Taxable income, as adjusted under 
§556(b)................................. $210,875 
Less deduction for dividends paid............$50,000 
Undistributed FPHCI.........................$160,875 

d. Dividends Paid Deduction 
(1) General 
Undistributed FPHCI is reduced by dividends paid during the taxable year, and also by "consent" dividends, agreed to be treated as paid by the corporation and its shareholders.307  
307§§556(a),  561(a), and 565. For  a complete discussion of the dividends-paid deduction, see 797 T.M., Personal Holding Companies. 
(2) Definition of Dividend 
Dividends eligible for the dividends paid deduction are defined essentially the same, with a few exceptions, as dividends generally under §316. 308 Under §316, certain distributions that  do not resemble dividends are nevertheless characterized as such and would  also be considered dividends for purposes of the dividends paid deduction  provided they come within none of the exceptions.309  
308562(a); Regs.  §1.561-2(a).  
309See, e.g., PLR 7917101, involving a  stock redemption treated as a distribution. 
Unlike domestic foreign personal holding companies, foreign personal holding companies are not allowed the carryover dividend in  §§561(a)(3) and 564 for purposes of computing the dividends  paid deduction.310  
310Regs.  §1.564-1(a). 
The regulations provide certain presumptions for determining when a dividend is received.311 If a  dividend is paid by check bearing a date within the taxable year, and the  check is deposited in the mail, a presumption arises that the dividend was  paid in such year (the mail box rule). Payment to an authorized agent of a  shareholder is deemed payment to the shareholder. Crediting the amount of the  dividend to the account of the shareholder does not entitle a corporation to  a dividends-paid deduction unless it is shown to the satisfaction of the IRS  that such crediting constituted payment within the taxable year. However, the  determination of whether a corporation has paid a dividend during its taxable  year does not depend on the corporation's method of accounting.312  
311Regs.  §1.561-2(a)(2)-(7).
312Regs. §1.561-2(b). 
The dividends paid deduction arising from the distribution of property is the adjusted basis of the property in the hands of the corporation. The shareholder, however, is taxed on the full fair market value of the property. 313 After some conflicting decisions, this regulation was eventually declared valid by the Supreme Court.314  
313Regs. §1.562-1(a).
314Fulman v. U.S.,  434 U.S. 528 (1978). 
A liquidating distribution by an FPHC does not affect the calculation of the corporation's undistributed FPHCI for that tax year. Instead, the U.S. shareholders are effectively taxed on the proceeds through the hypothetical dividend mechanism.315 That, in turn, provides them with additional basis in the stock, which offsets  the gain from the liquidating distribution. As a result, the same amount is  taxed, but it is taxed as ordinary gain rather than as capital gain.   
315§551(b). 
(3) Preferential Dividends 
Dividends do not qualify for the dividends paid deduction unless they are non-preferential, meaning: 
(1) The dividend is pro rata within a given class of stock; and 
(2) The dividend is not preferential to one class of stock versus another except to the extent the terms of the stock classes (without reference to any waivers of shareholder rights) provide for a preference of one over the other.316  
316§562(b). 
If preferential, the entire dividend is denied deduction treatment, not just the preferential portion.317 Two separate distributions, even if made in the same year, may not be considered together in determining whether a distribution was preferential. 318 Accordingly, companies should be cautious, for instance, that any distribution on common stock is made only after or at the time all preferred stock preferences have been met.319 The  regulations, however, do allow a distribution made partly in actual dividends  and partly in consent dividends to be treated as one distribution when testing  for preferential purposes.320  
317Regs.   §1.562-2(a).  
318Regs. §1.562-2(b) Ex. (1).
319See Regs.  §1.562-2(b) Ex. (3).
320Regs.  §1.565-4. 
(4) Late-Paid Dividends 
An FPHC may designate a distribution, or a portion of a distribution, made by the 15th day of the third month after the close of its taxable year as a dividend for the prior tax year, up to the amount of its undistributed FPHCI. 321 The  designation is made on an attachment to Form 5471, schedule N. 322 The designation must set forth the date of distribution and  a statement indicating the extent to which the distribution is being taken  into account under §563(c). The designation  must be signed and dated by a duly authorized corporate officer of the  corporation.323   
321§563(c). 
322Rev. Proc. 90-26, 1990-17 C.B. 16,  §4.01. 
323Prop. Regs.  §1.563-3. 
(5) Consent Dividends
"Consent" dividends present an administratively simple way for shareholders to effectively take a dividend and immediately put the money back into the corporation. Consent dividends are useful to ensure non-preferential treatment when some shareholders want dividends and others do not.
A consent dividend may be taken only by a shareholder who owns "consent stock" on the last day of the taxable year of the corporation. Consent stock is generally common stock or fully participating preferred stock,324 since it must be entitled to a share in distribution of all earnings and profits after dividends are paid on preferred stock.325
324 The participating rights, however, must be unlimited. Regs. §1.565-6(a)(1). 
325 §565(f)(1). 
Note: A consent dividend is not effective if it results in a preferential dividend.326
326 §565(b)(1). 
The amount of the consent dividend is treated like amounts includible as undistributed FPHCI in the gross income of U.S. shareholders: (1) the amount is includible in gross income as a dividend; (2) the basis of the shareholder's consent stock is increased by the amount; and (3) the amount reduces the corporation's E&P and is deemed to have been contributed to the corporation as paid-in surplus.327
327 §565(c); Regs. §1.565-3(a). 
To arrange a consent dividend, shareholders must prepare and execute Form 972, which must be filed by the corporation no later than the due date for the corporation's return.328 In addition, the corporation must file Form 973. 
328 Regs. §1.565-1T(b)(3).
7. Inclusion in U.S. Shareholders' Income 
a. Hypothetical Dividend Distribution 
The "U.S. shareholders" of an FPHC on the last day in the corporation's taxable year on which it met the ownership test for FPHC status (the last date on which a U.S. group existed) must include in gross income, as a dividend, an appropriate portion of the corporation's undistributed FPHCI. 329 These rules  apply to every U.S. shareholder, whether or not the shareholder is included in  the U.S. group.330  
329§552(a).
330Regs.  §1.551-2(a). 
A shareholder is not required to report undistributed FPHCI if he was not a shareholder on the last day in the taxable year of the company on which a U.S. group existed. Thus, a U.S. shareholder who disposes of his shares is not taxed on any undistributed FPHCI if a U.S. group continues to exist after the disposition. 
(1) Definition of "U.S. Shareholder" 
A U.S. shareholder is any U.S. person (U.S. citizens and residents as well as domestic corporations, partnerships, and fiduciaries qualify) who owns any shares of the corporation.331  
331§551(a). 
(2) Special Indirect Ownership Rule 
The constructive ownership rules which apply in determining whether the corporation is an FPHC do not apply in determining which, and to what extent, U.S. persons are taxed.332 A special indirect ownership rule applies in determining inclusions  in the income of U.S. shareholders, however. Stock of an FPHC owned by a  foreign entity that is not another FPHC is considered owned proportionately  by its shareholders, partners, or beneficiaries.333 The proportionate interest of  U.S. persons holding stock in a corporation with more than one class of stock,  presumably would be determined in accordance with the percentage of  undistributed FPHCI that would be distributed to each in a hypothetical  dividend.334  
332§554(a).
333§551(f).
334Cf. Regs.  §1.951-1(e)(2). 
In addition, a person may be considered to actually own stock that he is under contract to buy, or for which he holds an option to buy, if the burdens and benefits of the stock have passed to him.335  
335Rev. Rul.  82-150, 1982-2 C.B. 110. 
b. Amount of Hypothetical Dividend 
(1) General 
Each U.S. shareholder owning stock on the last day in the FPHC's taxable year in which the stock ownership test is met must include in gross income, as a dividend, the amount that would have been received as a dividend on that day had the corporation distributed its undistributed FPHCI for the taxable year.336 The statutory definition of undistributed FPHCI does not limit the hypothetical dividend amount to the current and accumulated earnings and profits of the FPHC. Nevertheless, in PLR 199939037 the IRS informally concluded, based on the §551(b) statutory language ("the amount which would have been received as a dividend") as well as the overall structure of the FPHC and PHC  regimes, that just as current and accumulated earnings and profits limit the amount treated as a dividend under §316(a) so too do current and accumulated earnings and profits limit the amount of undistributed FPHCI that may be included in the gross income of the FPHC's U.S. shareholders.
336§551(b). 
(2) Multiple Classes of Stock 
If the corporation has more than one class of stock, the hypothetical dividend is first considered to satisfy any preferential distributions, in accordance with the terms of each class of stock.337 This rule prevails  irrespective of the motive for the creation of preferred stock.338 As a result, preferred stock can be issued to nonresident  aliens to cause the first portion of undistributed FPHCI to be allocated to  them.  
337Regs.  §1.551-2(c).
338Barnette v. Comr., T.C. Memo 1992-371 (existence of preferred  stock may not be ignored even if the sole purpose for its creation is tax  avoidance). 
(3) Partial-Year Foreign Personal Holding Company Status 
If a foreign corporation is an FPHC on the last day of its taxable year, its entire amount of undistributed FPHCI is considered to be distributed as a dividend in calculating tax of the U.S. shareholders.339 This is the case even if the  foreign corporation has not been an FPHC for the entire year. In fact, the  entire amount is considered distributed even if the corporation qualifies as  an FPHC only on the last day of its taxable year. 
339§551(b). 
On the other hand, if the U.S. group of an FPHC ceases to exist before the last day of its taxable year, the hypothetical dividend is the percentage of the corporation's undistributed FPHCI for the year that is the same as the ratio of the part of the taxable year up to and including the last day that a U.S. group existed over the entire taxable year.340  
340Id. 
Moreover, harsh results may occur from the interaction of these rules and the income requirement for FPHC status. 
 Example (55)—Inclusion by Former Owner
A, a U.S. shareholder, owns 100% of the outstanding stock of a foreign  corporation whose income is derived solely from manufacturing operations and  whose taxable year is the calendar year. A sells all his stock in the foreign  corporation to B, a nonresident alien, on March 31, when the foreign  corporation has $20,000 in income derived from the active conduct of a  manufacturing business. B immediately causes the foreign corporation to sell  all its assets for cash, which the corporation invests, earning $30,000 in  passive income during the remainder of the taxable year. The foreign  corporation is an FPHC since it was wholly owned by a U.S. shareholder during  the first three months of its taxable year and 60% of its gross income for the  taxable year ($30,000/$50,000) was FPHCI (interest). A is required to include  in his gross income 3/12 of the undistributed FPHCI of the foreign corporation  ($12,500) because he was a U.S. shareholder on the day in the taxable year of  the corporation which was the last day of its taxable year in which a U.S.  group existed. This is so even though during the entire period of A's  ownership the foreign corporation was an operating company and A had no  control over its operation after the sale of his stock.341 
341It is possible, however, that an equitable exception to this type  of situation would be found by a court. Cf. Marsman v. Comr.,  205 F.2d 335 (4th Cir. 1953). 
Despite the statutory language, the Fourth Circuit, in  Marsman v. Comr.,342 declared an exception to the harsh result in  the above example. In Marsman, all of the stock of a Philippine corporation  that met the gross income requirement was owned by a citizen and resident of  the Philippines. She became a resident of the United States near the close of  the corporation's taxable year. Thus, a U.S. group existed, and the corporation was an FPHC, at the end of its taxable year. Under the literal terms of the statute, the shareholder would have had to report all of the company's undistributed FPHCI for the entire taxable year. The Tax Court so held, but the Fourth Circuit reversed, reasoning that the statute should not be applied literally without reference to the purpose for which it was enacted. Instead, the court charged the shareholder with that portion of the undistributed FPHCI that the company actually received while she was a resident.  
342205 F.2d 335 (4th Cir. 1953).  Further proceedings in this case, not relevant to the issues discussed here,  may be found at 216 F.2d 77 (4th Cir. 1954), cert. denied,  348 U.S. 943 (1955). 
Subsequently, in Gutierrez v. Comr.,343 the  Tax Court followed Marsman, but rather than calculating undistributed FPHCI  on the basis of income received by the corporation during the shareholder's  period of nonresidency, the court applied the percentage of days of residency  in the year to the total undistributed FPHCI.  
34353 T.C. 394  (1969), aff'd, 72-1 USTC ¶9121 (D.C. Cir. 1971) (per curiam). 
(4) Restrictions on Actual Dividends 
In Eder v. Comr.,344 which concerned an FPHC organized in Colombia, the exchange control laws of Colombia prevented the transfer of the company's undistributed FPHCI outside that country's boundaries. The U.S. shareholders claimed that, in spite of the clear language of the statute, they should not be required to report this income. The court held that they were able to spend the "blocked" income in Colombia and therefore could receive "economic satisfaction" from the income. Thus, they were taxable on this income, but only to the extent of "economic satisfaction in Colombia . . . measured in American dollars." 345 The case was remanded to the Tax  Court for a determination of the value of the "blocked" income in American  dollars. The Tax Court found that the value of the "blocked" Colombian pesos  was one-half the value of freely exchangeable pesos.346  
344138 F.2d 27 (2d Cir. 1943),  rem'd, 47 B.T.A. 235, on remand, T.C. Memo 1944-156.  
345138 F.2d 27, 28.  
346T.C.  Memo 1944-156. 
In Alvord v. Comr.,347 95% of the outstanding shares of an FPHC was acquired by a U.S. resident near the end of its taxable year. The Treasury Department was in control of the financial affairs of the corporation and refused to permit any distributions to its shareholders. The Tax Court had declined to follow Marsman, and held that the U.S. shareholder should report 95% of the undistributed FPHCI for the year. The Fourth Circuit reversed, but not on the ground of the Marsman decision. Rather, the court cited Eder,  and determined that the U.S. shareholder should report none of the undistributed  FPHCI because he had not received any "economic advantage" from it, since the government prohibited distributions by the corporation.  
347227 F.2d 713 (4th Cir. 1960). 
In Mariani Frozen Foods, Inc. v. Comr.,348 however, the  court held that a restriction did not limit undistributed FPHCI when a  voluntary action caused the dividend restrictions to apply. The U.S.  shareholders transferred a 20% interest in their FPHC to a foreign corporation.  The FPHC's articles of incorporation gave the 20% holder the power to prevent  dividend declarations. The court reasoned that a U.S. group under the FPHC  rules is presumed to have the power to declare dividends and that, in any  case, no attempt was made by the U.S. shareholders to actually declare  dividends.  
34881 T.C. 448 (1983), aff'd on other grounds sub nom. Melinda L. Gee  Trust v. Comr., 761 F.2d 1410 (9th Cir. 1985). 
8. Effect on Stock Basis 
The notional dividend included in gross income of an FPHC U.S. stockholder  increases his basis in the stock of the foreign corporation.349 This adjustment avoids  again taxing the shareholder when he disposes of his stock in the corporation,  or receives a liquidating distribution from it.  
349§551(e). 
 Example (56)—Basis Increase
U.S. Citizen owns 75% of the stock, with a basis of 300, of Foreign  Personal Holding Corp. which has 100 of undistributed foreign holding company  income. Citizen includes 75 in gross income as a dividend. After the dividend  inclusion his basis in the stock is 375.350  
350See Regs.  §1.551-5(b), Ex. 2. 
The basis increase is conditioned on the inclusion of the dividend in gross income, and basis can, or must, be adjusted to take into account any changes in the amount of the income inclusion within a period six years from the filing date of the return that did, or should have, reported the dividend. 351
351See Regs. §1.551-5(b). 
 Example (57)—Basis Adjustment
Assume the same facts as Example 56, except that U.S. Citizen failed to  include the 75 in income. If the absence of that amount from his return is  not discovered until more than six years from the date he filed his return,  he gets no basis adjustment.352 But if the  IRS audited his return during the 6-year period, proposed a deficiency based  on inclusion of the 75 in gross income before the end of that period, and  Citizen petitioned the deficiency to the Tax Court, which decided in favor of  the IRS after the end of the 6-year period, Citizen gets an upward basis  adjustment of 75.353 
352Regs.  §1.551-5(b), Ex. 2. 
353See Mariana Frozen Foods Inc. v. Comr., 81 T.C. 448 (1983), aff'd on other grounds, 761 F.2d 1410  (9th Cir. 1985). 
The basis of a decedent's successor in the shares of an FPHC owned by the decedent at his death is equal to the lower of the decedent's basis or the fair market value of the shares at the date of his death.354  
354§1014(b)(5). 
9. Effect on Earnings and Profits 
An FPHC's E&P account is reduced by an amount equal to the  undistributed FPHCI. If the stock ownership test is met for the entire taxable  year, E&P is reduced by the full amount of the corporation's undistributed  FPHC income, even though not all of its shareholders are required to be taxed  on that income; viz., in the case of a nonresident alien who is a minority  shareholder. If the stock ownership test is met for only a portion of the  year, the adjustment to E&P is pro-rated based on the time during the  year that the corporation was an FPHC.355  
355§551(d). 
10. Later Actual Distribution 
When an FPHC makes an actual dividend distribution, if it has no current or accumulated E&P after adjusting its  E&P account for deemed distributions, the actual distribution is not  treated as additional gross income to the U.S. shareholder. His basis in the  shares would be reduced in an equivalent amount under the regular rules  relating non-dividend distributions to basis. If at the time of the actual distribution, the FPHC had accumulated E&P after the adjustments, the U.S. shareholder would report the actual dividend as gross income in an amount equal to the lesser of the distribution or the corporation's accumulated  E&P.356  
356See Regs.  §1.551-5(b), Ex. 1, 2.  
 Example (58)—Earnings Adjustment, Actual Distribution
In Example (56), above, assume that the remaining 25% of the stock of  Foreign Personal Holding Corp was owned by Nonresident Alien. In the current  taxable year, even though Nonresident Alien is not required to include his 25  ratable share of undistributed FPHCI in gross income subject to U.S. tax, the  corporation reduces its E&P by 100. After that adjustment, assume the  corporation has no accumulated E&P for the current year or current E&P  for the following year. In the following year, the corporation makes a  distribution of 40. In the absence of E&P, the amount is a nontaxable return  of capital that is not included in the gross income of either taxpayer. If  U.S. Citizen had properly reported the deemed dividend of 75 in gross income,  his basis of 375 would be reduced by his 30 share of the nontaxable  distribution. If he had failed to report the dividend, his unadjusted basis  of 300 would be reduced by 30 to 270. 
11. Foreign Tax Credit 
An individual U.S. taxpayer generally does not qualify for a deemed-paid foreign tax credit, and so cannot claim a foreign tax credit for foreign taxes paid by his FPHC. And in any event, as pointed out above, undistributed FPHCI is arrived at after taking a deduction for foreign taxes into account. 
A U.S. corporation is eligible for an indirect foreign tax credit based on foreign tax paid by a foreign affiliate, and a notional dividend resulting from undistributed FPHCI will support a credit for foreign taxes paid.357  
357Regs. §1.902-1(a)(11).
 Example (59)—Indirect Credit Allowed
U.S. Corp owns all of the stock of Foreign Personal Holding Corp, which  owns all of the stock of Foreign Second-Tier Corp. Second-Tier Corp paid a  dividend to Foreign Personal Holding Corp, which made no distribution to U.S.  Corp. U.S. Corp reported dividend income as a result of the undistributed FPHC  income of Foreign Personal Holding Corp. U.S. Corp is entitled to the  indirect foreign tax credit for foreign taxes paid by Second-Tier Corp. 358 
358The IRS did not allow a credit in this situation until its issuance of the §902 regulations in 1996. See Rev. Rul. 74-59, 1974-1 C.B. 183, revoked by T.D. 8708, 1997-1 C.B. 137, 139.
12. Reporting Requirements
U.S. persons who are officers, directors, or 10% shareholders of an FPHC are required to file Form 5471 to report information in relation to their status.359 Every U.S. stockholder  who is required to include undistributed FPHC income on his return and who on  the last day on which the stock ownership test was met was the owner of 5% or  more in value of the outstanding stock of the FPHC is required to report  details of the foreign corporation's items of income, deduction and credit. 360 
359See the discussion of  Form 5471 at ¶7150, below.  
360§551(c). 
¶7130.04.B. Controlled Foreign Corporations
1. U.S. Shareholders' Current Income Inclusion
Generally, a U.S. person who owns shares in a foreign corporation does not include in his gross income the income of the foreign corporation until it is distributed to him. Unless the foreign corporation is engaged in a U.S. trade or business or receives U.S. source fixed or determinable income, it is not subject to U.S. tax. The tax deferral inherent in the ordinary Code rules that treat a corporation as a taxpayer separate from its shareholders is a strong incentive to U.S. persons to place income producing assets or business operations in foreign corporate form. Fungible income, such as interest, dividends or royalties, is particularly subject to that kind of manipulation.
As a result, the Code taxes certain kinds of undistributed earnings and profits of a "controlled foreign corporation" directly to its "United States shareholder," and thereby obviates the potential structural benefit for tax deferral. In addition, the Code provides that a constructive repatriation of earnings results in immediate tax to the U.S. shareholder.
A controlled foreign corporation (CFC) is a foreign corporation the U.S. shareholders of which own more than 50% of the combined voting power of its stock or more than 50% of the total value of the stock.361  However, even where the shareholder owns 50% or less of the voting shares of foreign corporation, the U.S. shareholders may be deemed to own greater than 50% of the combined voting power if such U.S. shareholders effectively retains control over the board of directors and operations of the corporation.361.1 A U.S. shareholder for this purpose is a U.S. person362  who owns 10% or more of the voting power of the controlled foreign corporation's stock.363  Thus, a U.S. person who owns no voting stock is not included in the 50% control group regardless of the value of the stock he owns.
361§957(a).
361.1See e.g. Koehring Co. v. U.S., 583 F.2d 313 (7th Cir. 1978); Weiskopf Est., 64 T.C. 78 (1975), aff'd per curiam w/o pub. op. 538 F.2d 317 (2d Cir. 1976). But see Framatome Connectors USA, Inc. v. Comr. 118 T.C. 32 (2002) (Deemed control not met where 50% U.S. shareholder had right to nominate majority of board because minority shareholders could block election of any director).
362A U.S. person is defined by §7701(a)(30), which is discussed in ¶7110. Section 957(c) modifies that definition for certain corporations organized in U.S. possessions.
363§951(b). Ownership may be direct, indirect, or constructive. See §958.
When a controlled foreign corporation's undistributed earnings and profits are taxed to its U.S. shareholders, their basis in its shares is increased as if a contribution to capital in that amount had been made. If an actual distribution is made of the amounts taxed earlier to the U.S. shareholders, the distribution is not taxed again, but their share basis is reduced.364  Corporate shareholders of a controlled foreign corporation can claim a deemed foreign tax credit for taxes paid by the foreign corporation in relation to the undistributed income. Individual U.S. shareholders can claim the indirect credit only if they elect to be taxed at corporate rates.365
364§959 and §961. See TAM 200141003 (In context of a deemed distribution of earnings under §304(a)(1), basis adjustments under §961 to stock of foreign subsidiary is translated at its historic basis (U.S. dollar value of previously taxed income under subpart F)).
365§902, §960, and §962.
The tax regime focuses both on the type of income earned and the use of the overall earnings of the controlled foreign corporation. Thus, "subpart F income" as defined in the Code is tainted income of the corporation that is included in its U.S. shareholder's income without regard to distributions made to him during the taxable year. Also causing a current income inclusion on the part of U.S. shareholders are the controlled foreign corporation's other earnings which constitute an increase in earnings invested in U.S. property.366
366§951(a)(1)(B). Subpart E income formerly included a CFC's earnings invested in excess passive assets, as enacted in the Revenue Reconciliation Act of 1993, P.L. 103-66, and effective for taxable years of CFCs beginning after 9/30/93 and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations ended. This provision was, however, repealed by the Small Business Job Protection Act of 1996, effective for taxable years of foreign corporations beginning after 1996 and for taxable years of U.S. shareholders within or with which those foreign corporation taxable years end.
The major components of subpart F income are "foreign base company income" and certain insurance income.367  Foreign base company income, in turn, has five subsets:
•   foreign personal holding company income includes passive income, net gains from the sale of stock and securities and from property that does not generate active income, related party factoring income, certain rents and royalties, net commodities gains367.1, and net gains from certain foreign currency activities367.2, net income from notional principal contracts, and payments in lieu of dividends derived from securities lending transactions;368 for taxable years of foreign corporations beginning after 1998 and before 2007, it does not include income derived in the active conduct of a banking financing or similar business;368.1 or qualified insurance income earned by a qualifying insurance company.368.2
•   foreign base company sales income is derived from related party sales directed through the country of the controlled foreign corporation that receives the income where that country is neither the place of origin nor the place of sale of the goods;369
•   foreign base company services income is derived from services performed outside the controlled foreign corporation's country of incorporation for, or on behalf of, a related person;370
•   foreign base company shipping income is derived from the use of a vessel or aircraft in foreign commerce, the performance of services directly related to that use, and the disposition of that aircraft or vessel;371  and
•   foreign base company oil related income is foreign oil related income other than extraction income.372
367§952(a)(1) and §952(a)(2). In addition, subpart F income includes amounts determined by reference to foreign boycott activity, certain illegal bribes or kickbacks to government officials, and income from countries that support terrorism.
367.1In T.D. 9039, 68 Fed. Reg. 4916 (1/31/03), the IRS adopted final regulations that exclude commodity gains from FPHCI that are derived from hedging transactions reasonably necessary to the conduct of any business by a producer, processor, merchant or manufacturer. See Regs. §1.954-2(f)(2)(iv).
367.2Regs. §1.954-2(g)(2)(ii)(C), T.D. 9039, now excludes from FPHCI currency gains related to "match funding" hedges, i.e. foreign currency denominated liabilities incurred to hedge dealer assets.
368§954(a)(1), §954(c), and §954(b)(5). Foreign personal holding company income for purposes of subpart F is similar to the like-titled income of foreign personal holding companies, with some differences that key it more closely to the specifics of subpart F. Some controlled foreign corporations use "hybrid branches" to shelter passive income from taxation under subpart F. In Notice 98-35, 1998-27 I.R.B. 35, the IRS stated its intention to issue regulations that would subject such income to subpart F. Prop. Regs. §1.954-1(c)(1)(i)(B), §1.954-2(a)(5), and §1.954-9 were accordingly issued, but, because of general concerns expressed as to subpart F, with a proposed effective date of taxable years commencing 5 years after publication of final regulations in the Federal Register (which will not occur prior to July 1, 2000) and a grandfather rule for payments under arrangements existing before June 19, 1998. On a more fundamental level, however, T.D. 9008, 67 Fed. Reg. 48020 (7/23/02), adopted final regulations for CFC taxable years beginning on or after July 23, 2002, requiring separate accounting and characterization for subpart F purposes of income derived by partnerships that have a CFC as a partner.
368.1§954(h), as amended by the 1999 Tax Relief Extension Act (P.L. 106-170) and the 2002 Job Creation and Worker Assistance Act (P.L. 107-147).
368.2§954(i). In Notice 2002-69, 2002-43 I.R.B. 730, the IRS published interim guidance on interest rates and loss payment patterns to be used in computing discounted loss reserves for purposes of §954(i).
369§954(a)(2), §954(d), and §954(b)(5).
370§954(a)(3), §954(e), and §954(b)(5).
371§954(a)(4), §954(f), and §954(b)(5).
372§954(a)(5), §954(g), and §954(b)(5).
The second major component of subpart F income is insurance income. Generally, insurance income includes income from the issuing or reinsuring of any insurance or annuity contract in connection with risks in a country other than the country in which the controlled foreign corporation is organized.373 There is a temporary exception, effective for taxable years of a foreign corporation beginning after December 31, 1998, and before January 1, 2007. Under this exception, subpart F income does not include income derived by a qualifying insurance company that is attributable to the issuing (or reinsuring) of an exempt contract that is treated as earned by the company (or its branch) in the company's (or branch's) home country for purposes of that country's tax laws. 374
373§953(a).
374§953(e), as amended by the 1999 Tax Relief Extension Act (P.L. 106-170) and the 2002 Job Creation and Worker Assistance Act (P.L. 107-147).
A de minimis exclusionary rule applies if foreign base company income and insurance income (determined for this purpose without regard to deductions) is less than the smaller of 5% of the controlled foreign corporation's gross income or $1 million. Also, if foreign base company income and insurance income (determined without regard to deductions) is more than 70% of the corporation's gross income, all of its gross income must be treated as foreign base company income or insurance income.375
375§954(b)(3).
Income (other than oil-related income), however, that is shown by the taxpayer to be subject to an effective foreign income tax rate greater than 90% of the U.S. corporate tax rate may not be included in foreign base company income or insurance income.376
376§954(b)(4).
The controlled foreign corporation's tainted income determined under those rules must be reduced by deductions properly allocable to that income to determine the amount of foreign base company income includible in the U.S. shareholder's gross income.377  The amount of the inclusion for any given year may not exceed the controlled foreign corporation's earnings and profits for that year.378
377§954(b)(5).
378§952(c)(1)(A). Section 952(c) allows offsets for prior years' deficits in earnings and profits, and "chain deficits." PLR 200419014 (CFC's qualified deficits can be transferred to another member of same affiliated group).
Separate and distinct from the inclusion of tainted subpart F income, the Code requires a U.S. shareholder to include currently in gross income the CFC's  "investment of earnings in U.S. property."379 
379§951(a)(1)(B), effective for taxable years of CFCs beginning after 9/30/93, defines this amount as "the amount determined under §956."
Under the earnings invested in U.S. property rules, the U.S. shareholder's income inclusion is his pro rata share of the lesser of:
(1) The excess (if any) of the shareholder's pro rata share of the average of the amounts of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter of such taxable year; over certain previously taxed earnings and profits; or
(2) The shareholder's pro rata share of the CFC's "applicable earnings."380
380§956(a)(1). The adjusted basis of the property is used as determined for purposes of computing E & P; subtracted from such adjusted basis is any liability to which the property is subject. §956(a) (flush language).
Applicable earnings are defined as the current and accumulated earnings and profits of the CFC reduced by distributions made during the year and reduced by previously taxed earnings and profits.381   United States property includes tangible property located in the United States, stock of a related domestic corporation, an obligation of a U.S. person (other than an unrelated person), and any right to use certain intangible property (e.g., patents and copyrights) to the extent acquired or developed by the foreign corporation for use in the United States.382
381§956(b)(1).
382§956(b). A number of exceptions and special rules apply to the term "United States property." For example, U.S. property does not include tangible property located in the United States if it is purchased here for export, nor are U.S. bank deposits considered an obligation of a U.S. person. See FSA 200031023 (IRS recharacterized transaction lacking economic substance as loans from foreign subsidiaries to U.S. parent and, thus investments in U.S. property).
For taxable years of foreign corporations beginning after September 30, 1993, and before 1997 and taxable years of U.S. shareholders within or with which  those foreign corporation taxable years end, income inclusions under the excess passive assets rules applied. Under the earnings invested in excess passive  assets rules, U.S. shareholders income inclusion was the lesser of two amounts: 383
383Former §956A(a)(1).
(1) The excess (if any) of the U.S. shareholder's pro rata share of the CFC's excess passive assets over that portion of the retained earnings of the CFC that was treated as having been previously taxed on account of excess passive assets;384  or
384Former §§956A(a)(1)(A) and 956A(a)(1)(B).
(2) The U.S. shareholder's pro rata share of the applicable earnings of the CFC (determined after the rules discussed above concerning inclusions based on the CFC's investment in U.S. property).385
385Former §956A(a)(2).
Excess passive assets were the excess, at the close of each quarter of the taxable year, of the average amount of passive assets held by the CFC over 25% of the average amount of total assets held by the CFC.386
386Former §956A(c)(1). The adjusted basis of the CFC's assets is used for these purposes. Id.
Applicable earnings were defined for these purposes as the CFC's current E & P and the CFC's E & P accumulated after Sept. 30, 1993. Subtracted from this amount in arriving at applicable earnings was any distribution made during the taxable year and post Sept. 30, 1993, accumulated E & P treated as previously taxed.387
387Former §956A(b). The amounts excluded as previously taxed were those previously taxed under §951(a)(1)(B) (the U.S. property real property rules) or under former §951(a)(1)(C) (the excess passive assets rules).
The definition of passive assets for these purposes generally was taken from the passive foreign investment company rules. Such assets are defined as assets held by the CFC that produce passive income or that are held for the production of passive income.388
388Former §956A(c)(2) (referring to the definition of passive income for passive foreign investment company purposes under §1296(b)).
Because earnings and profits included as tainted subpart F income could also support an increase in earnings invested in U.S. property or an investment in excess passive assets, the Code provides that earnings and profits may not be included twice in a U.S. shareholder's income. If the controlled foreign corporation's undistributed earnings and profits are included as subpart F income, they may not again be included as U.S. property or excess passive assets investment income.389
389§959(a)(2) and §959(a)(3).
A U.S. shareholder must include a pro rata share of the amounts described above in income in any taxable year in which the foreign corporation is a controlled foreign corporation for an uninterrupted period of 30 days and the U.S. shareholder owns shares in that corporation on the last day of the taxable year. The amount included is measured by the tainted income of the foreign corporation for its taxable year that ends with or within the taxable year of its U.S. shareholder.390
390§951(a).
2. Gain on Sale or Liquidation
When a U.S. shareholder sells or exchanges stock in a controlled foreign corporation, or receives a liquidating distribution, the gain recognized is treated as a dividend to the extent of the corporation's previously untaxed and undistributed post-1962 earnings and profits.391  This rule applies to any U.S. shareholder who owned, directly or indirectly, 10% or more of a foreign corporation's voting stock at any time during the five years before the date of the sale or exchange when the foreign corporation was a controlled foreign corporation. Where the controlled foreign corporation has paid foreign taxes, a U.S. corporate shareholder may be able to claim a deemed paid foreign tax credit (subject to any applicable limitations).392   If, however, the gain were treated as capital gain arising from the disposition of the foreign corporation's stock, no foreign tax credit would be available.
391§1248; PLRs 199908044-045 (Gain on sale of controlled foreign corporation stock that is treated as a dividend under §1248(a) qualifies for the §1248(b) tax limitation to a shareholder of an S corporation that held the stock).
392See §902; TAM 199906035 (Requiring coordination of earnings and credits under §1248 with those relating to regular dividends).
If the gain realized on the liquidation were not currently recognized because the U.S. shareholder owned 80% or more of the stock of the controlled foreign corporation, the U.S. shareholder would include in income an amount based on the untaxed and undistributed earnings and profits of the controlled foreign corporation.393 
393Section 332 liquidations are subject to the rules of §367(b), discussed below. See Regs. §1.367(b)-3.
¶7130.04.C. Passive Foreign Investment Companies
If a U.S. person disposes of stock in, or receives an excess distribution from, a passive foreign investment company (PFIC), he is liable for a special tax and an interest charge based on the value of the tax deferral he has enjoyed over the period of his investment in the company. If the PFIC is a qualified electing fund (QEF), the U.S. shareholder's current gross income includes his share of the company's current earnings and profits.394
394 1291 -  §1298.
A foreign corporation is a PFIC if 75% or more of its gross income for the taxable year is passive income of certain statutorily specified types, or if 50% or more of its assets by value produce or are held to produce that kind of income.395 There are exceptions from the definition of passive income designed to benefit certain foreign banks, insurers, FSCs, export trade corporations, and (for taxable years beginning after 9/30/93 and before 1998) dealers in securities. In addition, a foreign corporation that is a controlled foreign corporation with U.S. shareholders (as defined in §951(b)) is generally not a PFIC with respect to such shareholders for their years beginning after 1997.396
395 §1297(a). The taxpayer must use the adjusted basis instead of the value of its assets in applying the second test if the entity being tested for PFIC status is a controlled foreign corporation and may do so if the corporation is not publicly traded and makes a binding election to compute its value in this manner. §1297(f). 
396 §1297(b)(2)(A), (B), (D) and (e) and former §1296(b)(3). See Notice 89-81, 1989-2 C.B. 399 (Describing rules to be incorporated in regulations to expand the exception for banks to certain foreign banks not licensed to do a banking business in the United States); INTL-65-93, 60 Fed. Reg. 20922 (4/28/95) (Proposed regulations liberalizing the Notice 89-81 rules for the foreign bank exception and implementing former §1296(b)(3)(A), which treated as nonpassive any income derived by a CFC in the active conduct of a securities business if the CFC was either a U.S. registered broker or dealer or otherwise qualified for the exception to passive income under the proposed regulations, e.g., in Prop. Regs. §1.1296-6). See also REG-115795-97, 63 Fed. Reg. 39 (1/2/98) (Proposing amendments to Prop. Regs. §1.1296-4(e), concerning the treatment of interbank deposits as loans for purposes of the exception to passive income characterization of income derived in the actual conduct of a banking business).
An excess distribution is the part, if any, of a current year's distribution from the foreign corporation that exceeds 125% of the average distributions on the corporation's stock over the prior three years (or the shorter period for which the U.S. person has held its stock if less than three years).397
397 §1291(b)(2).
The U.S. shareholder who disposes of the stock in a PFIC or receives an excess distribution pays regular income tax on a deferred tax amount. That amount is determined by:
•  notionally allocating the income received in the disposition or distribution to the prior years in which it was generated by the foreign investment company;
•  determining the tax the shareholder would have paid on that income (at the highest applicable rate) had he received it in those years; and
•  adding to that tax a statutorily determined amount of interest on the deferred tax.398 The deemed foreign tax credit is available in relation to that income.399
398 §1291(c)(1). Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund,  is used to calculate the amount of the excess distribution, and the deferred tax amount thereon. Allocation of excess distributions must be set forth on a separate sheet attached to the Form 8621. See Instructions for Form 8621.
399 §1291(g)(1).
With respect to PFIC taxable years ending with or within taxable years of the shareholder beginning after 1997, a U.S. person who holds marketable stock in a PFIC can avoid the foregoing consequences by electing to mark-to-market the PFIC stock, thereby including in income each year the excess, if any, of the value of the PFIC stock at year end over the shareholder's adjusted basis in such stock.399.1
399.1 §1296(a). PFIC stock is considered marketable if it is regularly traded on a national securities exchange that is registered with the SEC or on the national market system established under §11A of the Securities and Exchange Act of 1934, or traded on a foreign stock exchange meeting other requirements relating to volume, disclosure, surveillance, etc. See Regs. §1.1296(e)-1.
Stock in a PFIC is marketable stock if the PFIC both is a foreign corporation comparable to regulated investment companies and offers for sale or has outstanding stock of which it is the issuer and which is redeemable at its net asset value.399.2
399.2 Regs. §1.1296(e)-1, published in T.D. 8867, 65 Fed. Reg. 3817 (1/25/00).
A U.S. person that owns marketable stock in a PFIC on the last day of the taxable year of such person, and that wants to make a mark-to-market election, must make a the election for such taxable year on or before the due date (including extensions) of the income tax return for that year on Form 8621.399.3 A mark-to-market election by a CFC is be made by its controlling U.S. shareholders and included with the Form 5471 information return for that CFC by the due date (including extensions) of the original income tax returns of the controlling U.S. shareholders for that year.399.4 A mark-to-market election by a CFC is binding on all U.S. shareholders of the CFC.399.5
399.3 Regs. §1.1296-1(h)(1)(i), T.D. 9123, 69 Fed. Reg. 24071 (5/3/04). A detailed discussion of the changes made to the mark-to-market rules under §1296 are beyond the scope of this summary. The changes made by T.D. 9123 are applicable for tax years beginning on or after May 3, 2004.
399.4 Regs. §1.1296-1(h)(1)(ii).
399.5 Regs. §1.1296-1(h)(1)(ii).
If the PFIC chooses, it may elect to be a qualified electing fund (QEF). In that case, the U.S. shareholder in the company includes in current income his pro rata share of the company's total earnings and profits.400 Those amounts are added to the shareholder's stock basis.401
400 §1293(a). 
401 §1293(d)(1).
Any U.S. person that is a shareholder of a PFIC may make a QEF election with respect to that PFIC.401.1 A shareholder making the QEF election must make the election on or before the due date (including extensions) for filing the shareholder's income tax return for the first taxable year to which the election will apply.401.2 The QEF election must be made in the original return for that year, or in an amended return, provided the amended return is filed on or before the election due date.401.3
401.1 Regs. §1.1295-1(d)(1).
401.2 Regs. §1.1295-1(e)(1).
401.3 Id. See Regs. §1.1295-1 and §1.1295-3, for rules relating to making and maintaining the election, including procedures for making retroactive elections; PLR 200245034 (Retroactive QEF election permitted where taxpayer reasonably relied on incorrect tax advice and met conditions in Regs. §1.1295-3(f)); PLR 199909042 (IRS consents to retroactive election to 1990); PLR 200303024 (Same); PLR 200327026 (IRS accepts defective QEF election made by foreign partnership under doctrine of substantial compliance).
The QEF election is accomplished by (i) completing Form 8621 in the manner required by that form for making the QEF election; (ii) attaching Form 8621 to its federal income tax return filed by the election due date for the shareholder's election year; and (iii) receiving and reflecting in Form 8621 the information provided in the PFIC Annual Information Statement, the Annual Intermediary Statement, or a combined PFIC statement for multiple PFICs for the taxable year of the PFIC ending with or within the taxable year for which Form 8621 is being filed.401.4
401.4 Regs. §1.1295-1(f)(1).
A PFIC shareholder is also permitted, by election, to defer actual payment of the tax liability arising from a QEF inclusion.401.5 The payment of the tax liability is deferred until the PFIC makes actual distributions of amounts previously deemed included in the U.S. investor's income.401.6 Interest on the deferred tax liability is accrued until the liability is actually paid at the normal rate for underpayments of tax.401.7 The election to defer payment of tax is made by the shareholder by (i) attaching to its return for the year of the election Form 8621 or a statement containing the information and representations required by the regulations and (ii) filing a copy of Form 8621 or the statement with the Internal Revenue Service Center, P.O. Box 21086, Philadelphia, Pennsylvania 19114.401.8
401.5 §1294(a)(1).
401.6 §1294(c).
401.7 §1294(g), Regs. §1.1294-1T(b)(1).
401.8 Regs. §1.1294-1T(d)(1).
Amounts actually distributed that have been included in a shareholder's income as a PFIC distribution are not again taxed. Instead, they are treated as a non-dividend distribution which reduces the E&P of the PFIC.402 Such distributions also reduce the taxpayer's basis in his shares.403
402 §1293(c). If, however, the PFIC is a controlled foreign corporation, inclusions under the PFIC provisions are treated as §951(a)(1)(A) inclusions.
403 §1293(d)(2).
Corporate shareholders who receive payments from a QEF are entitled to claim a credit for the foreign taxes paid by the fund.404
404 §1293(f).
Under proposed regulations, effective for foreign corporation taxable years ending after Sept. 27, 1996, a foreign employer other than a CFC is not treated as the owner of any portion of a foreign nonexempt employees' trust for purposes of the above rules. There is an exception for cases in which a principal purpose for transferring property to the trust is to avoid classification of a foreign corporation as a PFIC or, if the foreign corporation is classified as a PFIC, in cases in which a principal purpose for transferring property to the trust is to avoid or to reduce taxation of U.S. shareholders of the PFIC.405
405 Prop. Regs. §1.1297-4(a)(1).
¶7130.04.D. Disposition of Stock in Foreign Investment Companies
Ordinary income treatment results from gain on the sale of stock in a foreign investment company to the extent of the taxpayer's ratable share of the post-1962 earnings and profits of the company accumulated while the taxpayer held the stock.406 A foreign investment  company is a foreign corporation that is registered under the Investment  Company Act of 1940, either as a management company or a unit investment  trust, or that engages in the business of investing or trading in certain  securities, commodities or futures contracts.407 If a corporation is both a  foreign investment company and a controlled foreign corporation, the gain on  its sale is taxed under the rules for controlled foreign corporations subject  to subpart F.408
406§1246(a).
407§1246(b).
408§1246(a)(2)(B)(i).
The provision states that the gain is characterized as ordinary income but does not classify it as a dividend. Thus, no foreign tax credit may be claimed by the shareholders for foreign taxes paid by the foreign investment company.
¶7130.04.E. Accumulated Earnings Tax on Foreign Corporations
 Like domestic corporations, foreign corporations that accumulate earnings beyond the reasonable needs of their business are exposed to the accumulated earnings tax.409  However, foreign personal holding companies and passive foreign investment companies are not subject to the accumulated earnings tax.410
409§532; Regs. §1.532-1(a)(1).
410§532(b)(2) and (4).
The accumulated earnings tax applies to a foreign corporation with respect to its U.S. source income if any of its shareholders are subject to tax on its distributions as a result of being U.S. citizens, resident aliens, nonresident aliens subject to tax on U.S. source income, or foreign corporations if a beneficial interest in the corporation is owned by any of the foregoing persons.411  The tax is imposed on the corporation's accumulated taxable income, as defined by the Code, at a flat rate equal to the highest rate on dividends (e.g., 39.1% for 2001, 38.6% for 2002, and 15% for 2003, and thereafter).412
411Regs. §1.532-1(c).
412§531 and §535. See ¶5140 for a discussion of the accumulated earnings tax.
¶7130.05
Tax Incentive Devices for U.S. Persons' Foreign Operations
¶7130.05.A. Foreign Sales Corporations and the Extraterritorial Income Exclusion
A foreign sales corporation (FSC) was a foreign corporation established with a viable foreign presence and activity by a U.S. corporate parent to handle the foreign end of export transactions in specified types of property. The FSC provisions were repealed in 2000, although certain existing FSCs were allowed to continue in existence under transitional rules.412.1 The income of the FSC had to be established on an arms'-length basis or under an acceptable administrative equivalent. The foreign corporation had to be located in a foreign country which by treaty or other agreement permits the IRS to have access to its corporate records.413
412.1P.L. 106-519, the FSC Repeal and Extraterritorial Income Exclusion Act of 2000.
413Former §922(a) and former §927(e)(3).
If a foreign corporation qualified as a FSC, a portion of its foreign trade income was exempt from U.S. income tax, and that amount could be distributed as an untaxed dividend to its U.S. parent under the 100% dividends received deduction.414  Some of the qualification requirements were relaxed for "small" FSCs.415
414Former §921(a) and former §926.
415See former §922(b).
A FSC was a foreign corporation that:
•  Was formed under the law of a foreign country or U.S. possession that has an exchange of information agreement with the United States;
•  Had no more than 25 shareholders;
•  Had no outstanding preferred stock;
•  During the taxable year maintained an office in a foreign country that qualified under the first item mentioned above, kept its permanent books of account there, and kept necessary records at a location in the United States;
•  Had a board of directors that included at least one individual who was not a U.S. resident;
•  Was not a member of a controlled group that had a domestic international sales corporation (DISC) as a member; and
•  Had properly elected to be treated as a FSC.416
416Former §922(a).
A FSC's "export property" gave rise to "foreign trading gross receipts," which received the favored tax treatment. Export property was generally manufactured, produced, grown or extracted in the United States by a person other than the FSC for use or consumption outside this country by or through that corporation. Export property did not include intangibles and certain other specific items.417  Foreign trading gross receipts were those attributable to disposition of the export property, or its leasing for use outside the United States, and certain services in connection with its export or lease.418
417Former §927(a). In FSA 200019021, the IRS Chief Counsel advised that rights in film characters developed by a taxpayer were not export property within the meaning of former §927(a)(1) because they were subject to one or both of the major express exclusions under former §927(a)(2). In Microsoft Corp. v. Comr., 115 T.C. 228 (2000), the Tax Court held that copyrights in computer software masters did not constitute former §927(a) "export property" for purposes of determining former §924 foreign trading gross receipts under the law in effect prior to the Tax Reform Act of 1997 (P.L. 105-34), but was reversed by the Ninth Circuit, 311 F.3d 1178 (9th Cir. 2002), which held that the masters were "export property." However, for periods after 1997 computer software could qualify as "export property" and, because of its unusual nature in this context, raised some tricky legal issues. See FSA 200131012 (Software which the U.S. manufacturer licenses to controlled foreign partnerships or sublicenses to unrelated foreign end-users may qualify as export property when shipped directly to the end-users and the manufacturer may qualify as a related supplier of the FSC as to both the licenses and the sublicenses).
418Former §924(a). Other items were included in foreign trading gross receipts (FTGR), such as payments for certain kinds of engineering and managerial services. See also FSA 199935008 (FTGR includes gains on forward sales of foreign currency made by U.S. supplier to hedge anticipated receivables).
Exempt foreign trade income subject to the tax benefit was determined by arm's-length pricing or administrative standards determined under rules established by the IRS. If the arms'-length method was used, 15/23 of foreign trade income was exempt. Under the administrative pricing formulae, 30% was exempt.419  Those amounts were reduced by deductions properly allocable to exempt foreign trade income.420
419Former §923(a). See FSA 200026009 (Partnership with corporate partners should be treated as an aggregate for purposes of determining the fraction a FSC wholly owned by the partnership should use in calculating the exempt portion of its foreign trade income under the FSC administrative pricing rules of former §925).
420Former §921(b). See FSA 199935008 (Losses incurred from forward sales of foreign currency made by the U.S. supplier to hedge anticipated receivables must be allocated to the sales income and taken into account in determining the combined taxable income of the FSC and its related supplier and foreign trade income). Former Regs. §1.925(a)-1T(e)(4) authorized pricing redeterminations between a FSC and its related supplier (e.g., from changes in product groupings), provided among other things that the limitations period is open for both (Union Carbide Corp. v. Comr., 110 T.C. 375 (1998), CCA 200215003; and FSA 200049012) and both provide amended returns (see §6501(c)(7)) or other adequate notice to the IRS (FSA 199924016). Cf. FSA 200010027 (Neither the requirement that the FSC and the related supplier's taxable years be still open under the statute of limitations nor the requirement that any redetermination shall affect both the FSC and the related supplier contained in former Regs. §1.925(a)-1T(e)(4) apply to foreign sales corporations redeterminations initiated by the IRS).
The FSC's exempt foreign trade income was treated as noneffectively connected foreign source income. The remainder, together with any nonexempt income, was generally treated as U.S. source effectively connected income subject to current U.S. tax.421  Distributions of exempt income to a U.S. corporate shareholder generally qualified for the 100% dividends received deduction.421.1
421Former §921(d).
421.1Former §245(c). See PLR 200137038 (U.S. corporation that was part owner of a domestic limited liability company treated as a partnership for U.S. tax purposes that, in turn, owned a FSC was entitled to 100% dividends-received deduction on its distributive share of FSC dividends out of foreign trade income received by the LLC).
As a result of a World Trade Organization Dispute Panel determination dated September 20, 1999 and a WTO Appellate Body decision on February 24, 2000, the FSC regime was found to constitute a prohibited export subsidy under the Agreements on Subsidies and Countervailing Measures and Article 3.3 of the Agreement on Agricultural Goods and ordered to be revoked by October 1, 2000. The Congress responded with legislation that repealed the ability of any corporation to elect the FSC regime for transactions after September 30, 2000, provided existing FSCs with generous transition rules preserving their tax benefits for transactions prior to January 1, 2002 and transactions pursuant to a binding contract in effect on September 30, 2000, and replaced the FSC regime with an extraterritorial income exclusion for qualifying foreign trade income.422
422Rev. Proc. 2001-37, 2001-23 I.R.B. 1327 sets out elections for existing FSCs on their tax treatment after September 30, 2000, including the election to report transactions under the extraterritorial income exclusion rather than the FSC rules.
In general, under this latest exclusion regime, effective for transactions after September 30, 2000 and after any FSC transition period, a taxpayer of any type (an entity or natural person of U.S. or foreign residence) excludes extraterritorial income that is "qualifying foreign trade income," defined as the greatest of the following:
(A) 30% of the taxpayer's foreign sale and leasing income from the transaction;
(B) 1.2% of the taxpayer's foreign trading gross receipts from the transaction; or
(C) 15% of the taxpayer's foreign trade income from the transaction.422.1
422.1§§941(a)(1), 114.
Foreign sales and leasing income encompasses income from certain foreign solicitation, negotiation and contracting services and from advertising, transportation, financing and sales processing activities with respect to qualifying foreign trade property (defined generally as foreign destination property that is at least 50% U.S. content).422.2 Foreign trading gross receipts are generally defined as sale, leasing, and service income relating to qualifying foreign trade property,422.3 and foreign trade income is the taxable income from such gross receipts.422.4 The meaning of terms contained in the exclusion regime is to be determined by reference to comparable terms in the FSC regime.
422.2§941(c).
422.3§942(a). Qualifying foreign trade property is defined in §943(a).
422.4§941(b)
No deduction is allowed for expenses attributable to excluded income and no credit is allowed for foreign taxes that are otherwise creditable and are incurred with respect to excluded income.422.5 
422.5§114(c), (d)
The extraterritorial income exclusion is claimed on Form 8873, "Extraterritorial Income Exclusion," which is filled as part of the taxpayer's income tax return. As individual taxpayer will deduct the amount of the exclusion on Part V of Schedule C, while a corporation deducts it on page 1, line 26, of Form 1120. 
¶7130.05.B. Interest Charge Domestic International Sales Corporations
Domestic international sales corporations (DISCs) were sanctioned by the Code from 1971 to 1984 as a device to diminish and defer U.S. tax on certain export activities. As a result of a change in the law, income attributable to no more than $10 million of the corporation's qualified export receipts may qualify for tax deferral. As to that deferred income, the shareholders of the DISC are subject to an interest charge on the amount of the tax that would otherwise be due on the corporation's tax deferred income. The interest charge is computed as if that income had been distributed.423
423§§991, et seq.
As its name implies, a DISC is a domestic corporation used to generate income from export items produced in the United States, including in specified cases the lease of those items and providing services of U.S. persons. A DISC is not directly subject to income tax. Its shareholders pay tax on its distributed and undistributed income in excess of the income relating to the $10 million in sheltered qualified receipts.424
424§991, §995.
To the extent those qualified receipts are not taxed to the shareholders, they pay a charge based on the tax that would otherwise be due if the sheltered income had been distributed. The charge is determined by reference to base period Treasury bill rate.425  Income of the corporation attributable to qualified export receipts in excess of the $10 million cap are deemed to have been distributed, whether or not they were, and are currently taxable in the shareholders' hands.426
425§995(f). The IRS provides this rate annually. See, e.g., Rev. Rul. 98-55, 1998-47 I.R.B. 5 (5.34% is the base period T-bill rate, for the period ending Sept. 30, 1998); Rev. Rul. 99-52, 1999-50 I.R.B. 652 (4.80% is rate for period ending Sept. 30, 1999); Rev. Rul. 2000-52, 2000-48 I.R.B. 516 (5.96% is rate for period ending Sept. 30, 2000); Rev. Rul. 2001-56, 2001-47 I.R.B. 500 (4.41% is rate for period ending Sept. 30, 2001); Rev. Rul. 2002-68, 2002-45 I.R.B. 808 (2.18% is rate for period ending Sept. 30, 2002); Rev. Rul. 2003-111, 2003-45 I.R.B. 1009 (1.30% is rate for period ending Sept. 30, 2003).
426§995(b)(1)(E).
¶7130.05.C. Possessions Corporations
1. Taxable Years Beginning Before 1996
A possessions corporation is a domestic corporation that meets certain qualifying tests. It can elect a credit against statutorily specified types of its foreign source taxable income. That taxable income is determined under a detailed regime of pricing methods. The credit is an amount equal to its U.S. tax on a portion of particular kinds of possessions source income. Recapture rules apply to certain tax benefit items used before the possessions credit was elected, if any.
A domestic corporation qualifies as a possessions corporation if it meets two gross income tests:
•  At least 80% of its gross income for the three-year period that ends with the taxable year for which the credit is claimed must be from sources that are within a U.S. possession. For this purpose, the ordinary source rules of the Code apply, except that a special rule requires allocation of income for items produced in a possession and sold in the United States. The types of gross income applicable for this test are from the sale of goods, the performance of services, and interest, royalties, rent and dividends.
•  At least 75% of the possession corporation's gross income during that 3-year period must be from the active conduct of a trade or business within a possession.427
427§936(a). See MedChem (P.R.), Inc. v. Comr., 116 T.C. 301 (2001) (Shell corporation with Puerto Rican contract manufacturer did not qualify in 1992 for credit because without its own supervisory employees it could not claim the other's activities as its own), aff'd, No. 01-2251 (1st Cir. 7/10/02) (Agreed with T.C. analysis except no position on supervisory rule enunciated by T.C.). But see Electronic Arts, Inc. and Subsidiaries v. Comr., 118 T.C. 226 (2002) (Following Medchem Tax Court test for active business, held that contract manufacturing in Puerto Rico was active trade or business because of taxpayer's meaningful participation.)
Three kinds of foreign source income of a possessions corporation are considered for purposes of the credit:
•  Income from the active conduct of a trade or business within a U.S. possession;
•  Gain from the sale or exchange of substantially all of the assets used by the possessions corporation in the active conduct of its trade or business in the possession; and
•  Qualified possession source investment income.428
428§936(a)(1).
The corporation's possessions source business income is separately determined for each product the corporation produces (in whole or in part) in the possession. The product is identified by reference to its component products, integrated products, or end products.429
429Regs. §1.936-5(a), Q & A-1.  See generally Coca-Cola Co. v. Comr., 106 T.C. 1 (1996).
Qualified possessions source investment income is gross income which is derived from within a possession in which the corporation conducts an active business, less deductions properly allocated and apportioned to that income. The taxpayer must establish to the satisfaction of the Service that the income is generated from the investment in the possession of funds derived from (or used in connection with) the active conduct of its business in the possession.430
430§936(d)(2).
The possessions corporation can use one of three allowable methods of determining its possessions source income for each of the products it has identified.
A general method entails the ordinary rules of the Code for computing intercompany transfer prices,431  except for the treatment of income attributable to the use of intangibles. Income from intangible assets owned or used by the possessions corporation is not considered its income. Instead, it is treated as the income of its U.S. shareholders and taxed to them. The general method applies unless the possessions corporation elects one of the following two methods.432
431See §482.
432§936(h)(1). See Regs. §1.936-4, Q & A-4.
A cost sharing method is available to a possessions corporation that meets a significant business presence test. The cost sharing method permits the corporation to include in its product income a profit component for intangible assets used in its manufacturing process (but not in relation to intangible assets related to marketing). As a condition to the use of this method the possessions corporation pays a share of cost of the annual research cost incurred by its U.S. parent in relation to the identified product.433
433§936(h)(5)(C)(i).
A profit split method is also available if the significant business presence test is met, and if the possessions corporation itself manufactures or produces the identified product. Under this method the corporation's taxable income is considered to be 50% of the aggregate taxable income for the possessions corporation and the parent (as well as any related corporations) in relation to the product.434
434§936(h)(5)(C)(ii). See, e.g.,  Coca-Cola Co. v. Comr., 106 T.C. 1 (1996); FSA 199932021 (Where parent corporation also manufactures and sells the product, CTI must take parent's R & D into account even if this produces a loss that reduces qualified possession source investment income); FSA 199905014 (In computing combined taxable income under the profit split method, Regs. §1.936-6(b)(1) Q & A-12, which apportions production costs of component product before its sale to "unrelated parties," does not apply to possession product after its sale to non-affiliates, even if they are "related persons").
The significant business presence test, as a prerequisite to the use of the cost sharing or profit split methods, requires the possessions corporation to comply with one of three factors:
•  The total production costs (other than direct material costs) incurred in the possession in producing the identified product must be at least 25% of the difference between the gross receipts from the product's sales to unrelated persons and the direct materials costs for materials purchased from unrelated suppliers;435  or
•  No less than 65% of the direct labor costs of the possessions corporation and its U.S. parent (and involved related corporations) for the identified product must be incurred by the possessions corporation during the taxable year for services performed in the possession;436  or
•  A substantial capital investment in the possession may qualify as a significant business presence if no less than 50% of the direct labor costs of the possessions corporation and its parent (and involved related corporations) for the identified product are incurred by the possessions corporation as compensation for services performed in the possession, and in addition the direct labor costs of the possessions corporation plus its "base period construction costs" are at least 70% of the aggregate of those two items for the affiliated group. Base period construction costs generally are construction costs incurred during the current taxable year and the four preceding taxable years in relation to the production of the identified product.437
435§936(h)(5)(B)(ii)(I).
436§936(h)(5)(B)(ii)(II).
437Regs. §1.936-5(b)(8), Q & A-1 and -2.
The amount of the possessions corporation tax credit equals the U.S. tax liability attributable to the corporation's active business income from within possessions, gain from the sale of substantially all of its possession's assets, and qualified possessions source investment income. To the extent that amounts are physically received by the possessions corporation in the United States, they are not taken into account in determining its gross income from non-U.S. sources.438  The possessions credit cannot be applied against the U.S. environmental tax, the accumulated earnings tax, the personal holding company tax or the tax on the recovery of foreign expropriation losses.439   To the extent the possessions credit applies, no foreign tax credit is available as to that income nor is there a credit for taxes withheld by a possession on dividends paid to the parent if the dividend qualifies for the 100% dividends received deduction in the parent's hands.440
438§936(b).
439§936(a)(3).
440 See §243, §901(g), §936(c).
Note: Effective for taxable years beginning after 1993, the possession tax credit is limited with regard to business income.441  Under these rules the credit is subject to either of two alternative limitations: the "economic activity limitation" or the "percentage limitation."442   Under the economic activity limitation, the credit may not exceed the sum of: (1) 60% of qualified compensation (the aggregate amount of the corporation's qualified possession wages plus its allocable employee fringe benefit expenses); (2) an applicable percentage of certain depreciation deductions claimed for regular tax purposes; and (3) a portion of the possession income taxes the corporation incurs during the taxable year (if the profit split method is not used).443
441§936 as amended by the Revenue Reconciliation Act of 1993. P.L. 103-66, §13227.
442§936(a)(4). The percentage limitation comes in the form of an option available to the possession corporation. For taxable years after 1993, the percentage limitation must be elected by the possession corporation under §936(a)(4)(B) for its first taxable year beginning after 1993 and it applies to the year for which made and all subsequent years unless revoked. See Rev. Proc. 95-37,  1995-2 C.B. 393, for procedures applicable to this and other  post-1993 elections.
443§936(a)(4)(A).
The following portions of depreciation deductions are taken into account in determining the economic activity limitation: 15% of the depreciation allowances for short-life qualified tangible property (3-year or 5-year property); 40% of the depreciation allowances for medium-life qualified tangible property (7-year or 10-year property); and 65% of the depreciation allowances for long-life qualified tangible property.444
444§936(a)(4)(A)(ii).
"Qualified possession wages" are defined as wages paid or incurred by the possession corporation during the taxable year to any employee for services performed in a possession, but only if the services are performed while the principle place of employment is within the possession.445
445 §936(i)(1). The cumulative amount of wages for each employee for any taxable year may not exceed 85% of the maximum earnings subject to tax under the OASDI portion of Social Security. §936(i)(1)(B)(i).
"Allocable employee fringe benefit expense" is defined as the aggregate amount allowable to the possession corporation as a deduction for certain fringe benefits multiplied by the ratio of the corporation's qualified possession wages to the total amount of wages paid.446
446§936(i)(2).
The "percentage limitation" is simply a reduction of the otherwise available credit. The "applicable percentage" is phased in over a 5-year period to 40%. The following percentages apply for these purposes to the following years: 1994 - 60%; 1995 - 55%; 1996 - 50%; 1997 - 45%; and 1998 and thereafter - 40%.447
447§936(a)(4)(B)(ii).
A possessions corporation may not be a member of an affiliated group; however, such corporations are considered members of an affiliated group for purposes of allocating and apportioning interest expense.448
448Regs. §1.861-11(d)(1) and (2).
If a corporation with possessions operations is included in a consolidated return before electing possessions corporation treatment, when that election is made the corporation is disqualified from inclusion in the affiliated group.449   As a result, it may be necessary to recapture losses realized earlier while the possessions corporation was a member of the affiliated group. The main vehicle for that adjustment is through the reduction of its possessions source income and thus its accompanying tax credit.450
449§1504(b)(4).
450 See §904(f).
For alternative minimum tax purposes, regulations characterize possessions corporation stock as an asset that produces foreign source passive dividend income. The rules exclude a possessions corporation from an affiliated group solely for purposes of allocating and apportioning interest and certain other expenses for alternative minimum tax purposes.451
451 Regs. §1.861-11(d)(2) and §1.861-14(d)(2).
As a result of that exclusion, the stock of a possessions corporation is  taken into account as an asset of the affiliated group for asset-based  apportionment, solely for AMT purposes. The result is to increase, solely  for AMT purposes, the proportion of interest and certain other expenses  apportioned to foreign source passive income, and to reduce the proportion  of those expenses apportioned to foreign source general limitation income. 452
452Regs. §1.861-9(h)(5)  and Regs. §1.861-9T(g)(3).
2. Taxable Years beginning After 1995
The possessions credit is generally repealed for taxable years beginning  after 1995, subject to grandfather rules permitting existing credit claimants  to claim credits for a 10-year transition period.453 A special  transition rule applies to the credit attributable to operations in Guam,  American Samoa, and the Northern Mariana Islands, and a special credit applies  to Puerto Rico economic activity during the transition period.
453Small  Business Job Protection Act of 1996, §1601, adding  §936(j), terminating the credit and providing  grandfather rules, and §30A, providing a Puerto  Rico economic activity credit during the transition period.
a. Existing Credit Claimant
Whether a corporation is an existing credit claimant (ECC) is determined  separately for each possession.454 In general, a  corporation is an ECC with respect to a possession if it is engaged in the  active conduct of a trade or business within the possession on Oct. 13, 1995  and validly has elected the credit for its taxable year that includes that  date.455 If a binding contract was in place on that date and the business started before  1996, the corporation is considered an ECC.456 If an ECC adds a  substantial new line of business, it ceases to be an ECC as of the end of the  preceding taxable year.457
454§936(j)(10).
455§936(j)(9)(A).
456§936(j)(9)(C).
457§936(j)(9)(B). See Regs. §1.936-11(b) for the definition of a new line of business.
If a corporation is an ECC in taxable years beginning after 1995, it is  entitled to a credit, subject to various limitations discussed below, computed  separately for each possession.458
458§936(j)(10).
b. Qualified Possession Source Investment Income
The credit attributable to qualified possession source investment income  (QPSII) is available for QPSII received or accrued before July 1, 1996. 459  After that date, no credit is available for QPSII.
459Small Business Job Protection Act of 1996, §1601(c)(2).
c. Economic Activity Credit
(1) Applicable Possessions
With respect to Guam, American Samoa, and the Northern Mariana Islands,  the credit is fully available to ECCs until their first taxable year beginning  after 2005.460
460§936(j)(8).
(2) Corporations Using the Income Credit Method
ECCs using the income credit method continue to use the pre- 1996 rules  for taxable years beginning before 1998.461 For taxable years beginning after 1997 and before 2006, possessions business  income (PBI) eligible for the credit is capped.462
461  §936(j)(2)(B).
462§936(j)(3)(A).
The cap on PBI is computed by referring to the base period years, defined  as the three taxable years among the most recent five ending before Oct. 14,  1995, determined by disregarding the highest and lowest PBI years. 463 For this purpose, PBI is adjusted for inflation.464 The average of  the three years is the adjusted base period income,465 and serves as  the cap on the amount of PBI that can be taken into account in taxable years  beginning after 1997 and before 2006.466
463 §936(j)(5)(A).
464§936(j)(4)(B).
465§936(j)(4)(A).
466§936(j)(3)(A).
An ECC that elected the income credit method may revoke the election if it  does so no later than for its first taxable year beginning after 1996. 467
467§936(j)(2)(B)(ii).
(3) Corporations Using the Wage Credit Method
ECCs using the wage credit method to determine the credit attributable to  PBI, other than in Puerto Rico, continue to use the pre-1996 rules for taxable  years beginning before 2002.468 For taxable years  beginning after 2001 and before 2006, the PBI eligible for the credit is capped  in the same manner as that for the income credit discussed above. 469
468§936(j)(2)(A).
469§936(j)(3).
ECCs using the wage credit method for Puerto Rico are eligible for the  Puerto Rico economic activity credit for taxable years beginning after 1995  and before 2006.470 This credit  is computed similarly to the pre-1996 wage credit method, and is capped for  taxable years beginning after 2001 in the same manner as that for the income  credit discussed above.471
470§30A, added by  the Small Business Job Protection Act of 1996, §1601(b)(1).
471§30A(a)(1) (flush language).
¶7130.06
Commercial Transactions Between Commonly Controlled U.S. and Foreign Persons
In a commercial transaction between a U.S. person and a commonly controlled foreign person, if one leg of the transaction is outside of the United States there is a possibility for tax deferral or avoidance to the extent the common income stream deposits taxable income in the hands of the foreign person. The Code gives the IRS the power to examine those transactions with a view to determining the proper amount of income that should come to rest in the hands of the U.S. taxpayer, regardless of how the parties have characterized the transaction or computed the U.S. and foreign components of the jointly generated income.472
472§482.
Although the statutory device has frequently been applied to taxpayers under common control where both are U.S. persons, the IRS has used it aggressively in the area of foreign transactions.
The provision can apply whenever two persons are "owned or controlled directly or indirectly by the same interests."473  It can be used by the IRS to allocate, apportion or distribute gross income, deductions, credits or allowances between or among those parties in order clearly to reflect the income of each. The basic principle for the adjustment is that the transactions between the related parties should be on the equivalent of arms'-length terms. The most common areas in which adjustments may arise are highlighted below.
473Id.
Sales of goods between related parties. Transfer pricing adjustments have been one of the most fertile fields for income reattribution by the IRS. From its standpoint, three methods are available to test the arms'-length nature of an intercompany sales transaction and, if it is faulty, to adjust income accordingly. In order of preference of application they are:
•  Comparable uncontrolled price method. Under this method, the transfer price is determined by reference to prices charged to unrelated purchasers in comparable "uncontrolled sales." Alternatively, sales of the same product by two parties unrelated to the taxpayer or each other of a comparable sort could provide evidence of an arms'-length price.474
•  Resale price method.  In the absence of reasonably comparable sales, in transactions in which the related purchaser does not add a significant amount of value to the goods, the sales price may be reduced by an appropriate markup to determine the recast transfer price. The proper markup is arrived at by reference to other similar transactions of unrelated parties in reasonably similar circumstances within the industry or market.475
•  Cost plus method.  If the first two alternatives do not apply, the costs of the related seller in relation to the goods are determined, then increased by a profit percentage appropriate to the transaction to determine the transfer price. 476
•  Other methods.  Each of the three preferred methods depend wholly or to some extent on outside comparable transactions. If none exist, it is up to the taxpayer to arrive at an other "appropriate method" acceptable ultimately to the IRS and the courts.477
474 Regs. §1.482-2A(e)(2). 
475 Regs. §1.482-2A(e)(3). 
476Regs. §1.482-2A(e)(4). 
477 Regs. §1.482-2A(e)(1)(iii). See Sundstrand v. Comr.,  96 T.C. No. 12 (1991) for an application of this method. 
Loans or advances.  If interest on a loan between related parties is not at an arms'-length rate, interest income may be reallocated between the parties. To determine whether the correct amount of interest has been charged by the parties, the factors to be considered include the principal amount, the credit position of the borrower, whether security for the loan is involved, the term of the loan and prevailing interest rates for similar transactions. A limited safe haven test is provided. If the interest falls within a range of 100% to 130% of the applicable federal rate on certain federal debt instruments, no adjustment is warranted.478
478 Regs. §1.482-2(a). The safe haven method does not apply where the lender is simply passing on a borrowing, or the lender-borrower is in the business of making loans, or the loan is not in dollars. 
Services.  If a person performs marketing, managerial, administrative, technical or other services for a commonly controlled person either at no charge or at a charge that departs from an arms'-length rate, the IRS may determine a charge that is equivalent to that rate. Incidental services do not require a reallocation. In the absence of evidence of what an actual arms'-length charge should be, the adjustment is based on the costs and deductions incurred in relation to the services by the group member who provides them. If the services are an integral part of the business of the provider (e.g., they are also performed in  part for other parties), a profit factor is added.479
479Regs. §1.482-2(b). 
Rents and royalties.  For tangible property not leased to a related party at a proper rate, the IRS can make a readjustment based on arms'-length rent that would have been charged to unrelated parties under the same circumstances. If the lessee of tangible property subleases it to a related party, the amount of the rent must be at least an amount equal to the sublessor's deductions in relation to the property.480
480  Regs. §1.482-2(c). A more appropriate  rate can be used if proven, and the safe haven of rent equal to costs does not apply if the lessor or the related lessee is in the rental business. Regs. §1.482-2(c)(2)(iii)(B).
Where intangibles are transferred to a related party in a nondispositive transaction, generally the IRS will look for royalties that are "commensurate with the income attributable to the intangible."481  That so-called "super royalty" requirement may entail a continuing adjustment of the royalty rate in order to comply with the standard.
481§482, last sentence. 
If the IRS makes an adjustment to items of income or deduction on one side of a related-party transaction, a correlative adjustment is made to the other end of the income stream.482  The primary adjustment or the correlative adjustment may have an effect on the foreign tax credit of one or the other of the parties by resourcing income or otherwise affecting the limiting fraction for the credit. Tax treaties may contain provisions to allow adjustments to take reallocations into account.
482 Regs. §1.482-1(d)(2). 
• For a further discussion of §482, see ¶3600.
¶7130.07
Organization of Foreign Corporations and Other Outbound Transfers
¶7130.07.A. Organization of Foreign Corporations: Section 367
The transfer of appreciated assets out of the United States in a transaction that would normally qualify for nonrecognition treatment may be an occasion for tax avoidance. For example, if a U.S. parent corporation transfers property with a value in excess of its basis in the process of creating a foreign subsidiary and takes back all of the stock of the new foreign subsidiary, no gain would be recognized on the transfer under the normal rules.483  If the foreign subsidiary then sold the asset, its gain would not be immediately subject to U.S. tax, assuming no other operative facts.
483§351. 
In contrast, if the U.S. parent had sold the asset and contributed the resulting cash to the subsidiary, the parent would have realized taxable gain on the transaction. To avoid that kind of result the Code provides that the transfer of appreciated property to a foreign corporation in the case just described results in a "toll charge" to the U.S. parent which causes it in effect to realize the untaxed gain.484  In general, the issue arises in three areas:
•   outbound transactions in which assets held in the United States by a U.S. corporation are transferred to a foreign subsidiary;
•   inbound transactions that deal with the transfer of foreign assets by a foreign person to a U.S. person; and
•   foreign-to-foreign transactions in which assets are transferred from one foreign person to another, where both foreign persons are ultimately controlled by U.S. persons.
484§367. 
The discussion immediately following covers outbound transactions. The other two types are outlined in ¶7130.09 and ¶7130.10, below.
In general the nonrecognition provisions applicable to organization, reorganization and liquidation of corporations are predicated on the statutory assumption that the taxpayer-parties to the transaction are corporations. The seemingly anomalous but effective mechanism for selectively canceling out nonrecognition treatment is to deem a corporate party a noncorporation. 485
485§367(a)(1). For example, §351(a) says that gain (or loss) is not recognized if property is transferred to a corporation  solely in exchange for its stock. Section 367(a) states that in a §351 transaction if a U.S. person transfers property to a foreign corporation, the foreign corporation is not, for purposes of determining the extent to which gain is recognized on the transfer, considered to be a corporation. As a result, the realized gain is exposed to recognition. 
The outbound transactions excluded from nonrecognition treatment are:
•  distributions made to a foreign shareholder in the course of the complete liquidation of a U.S. corporation;486
•   a U.S. person's contribution of appreciated property to a foreign corporation controlled by the U.S. person in exchange for the foreign corporation's stock;487
•   the exchange of stock or securities in certain reorganizations that involve a foreign corporation;488
•   transfers in the course of a corporate reorganization where one of the corporations is foreign and additional consideration is received;489  
•   the exchange of property in a reorganization solely for stock or securities in another corporation where one of the parties to the transaction is a foreign corporation;490 and
•   certain distributions of stock or securities in 80%-or-more controlled subsidiaries by a domestic corporation to a foreign person, whether or not  in a divisive reorganization.491
486§332; §367(a). 
487§351; §367(a). The exchange of stock is treated as having occurred even if it is not actually made. 
488§354; §367(a). 
489§356; §367(a). 
490§361; §367(a).
491§355; §367(e)(1); Regs. §1.367(e)-1. In general, if the stock distributed is foreign, the distribution is taxable without exception, but if the stock distributed is domestic, the distribution can be nontaxable. See Regs. §1.367(e)-1. Note that §367(e)(1) and the regulations thereunder apply to distributions to foreign individuals as well as to foreign corporations.  In addition, the mechanism for canceling out nonrecognition is not treating the  foreign distributee as a noncorporation (as  §367(a)(1) does in the transactions  described above), but rather a direct requirement that gain is to be recognized  on the transaction. See Regs.  §1.367(e)-1(b)(1).
Several exceptions and special rules apply. The major exception under §367(a) is that nonrecognition continues to apply to assets transferred to a foreign corporation if they are used in the active conduct of a trade or business carried on by the foreign corporation outside of the United States. 492
492§367(a)(3)(A). Certain  kinds of assets are excluded from the exception: inventory, copyrights,  installment obligations, foreign currency, leased property and several other  kinds of items. §367(a)(3)(B). Also  excluded are assets of a U.S. person's foreign branch that are transferred  to a foreign person in one of the first five kinds of transactions described in the  text preceding this note, to the extent of branch losses previously deducted  by the U.S. person. The result is the losses are in effect recaptured through the toll charge. §367(a)(3)(C).
In addition, where a U.S. person transfers certain kinds of intangible property to a foreign corporation the transaction is cast as a sale for a consideration of annual royalty payments over the remaining useful life of the intangible.493  The resulting "super royalty" payments must be commensurate with the income attributable to the intangible, and the amount is adjusted annually to reflect actual income received.494  A special rule treats the royalties as ordinary income. 495   A later disposition of the intangible by the transferee is also considered a taxable event.496 
493§367(d). 
494Regs. §1.367(d)-1T(c). 
495§367(d)(2)(C). 
496§367(d)(2)(A)(ii)(II).
¶7130.07.B. Other Outbound Transfers
1. Rules Effective August 5, 1997
The Taxpayer Relief Act of 1997 repealed the excise tax regime which formerly applied to certain outbound transfers of property effective for transfers made on or after August 5, 1997.497
497The Taxpayer Relief Act of 1997, P.L. 105-34. The former excise tax regime is discussed at ¶7130.07.B.2, below.
In place of the excise tax that applied to transfers to foreign trusts or estates, a provision was added which, except as provided in regulations, generally treats a transfer of appreciated property by a U.S. person to a foreign trust or estate as a sale of such property for fair market value. 497.1 Such a transferor must recognize as gain the excess of the fair market value of the property transferred over its adjusted basis. For purposes of this general rule, if a trust which is not a foreign trust becomes a foreign trust, such trust is treated as having transferred, immediately before becoming a foreign trust, all of its assets to a foreign trust. This provision does not apply to a transfer to the extent any person is treated as the owner of the foreign trust under the grantor trust rules.
497.1§684, effective Aug. 5, 1997. In T.D. 8956, 66 Fed. Reg. 37897 (7/20/01), the IRS issued regulations that explain, and provide certain exceptions to, the application of §684. See Regs. §§1.684-1 through 1.684-5. In connection with repeal of the federal estate tax, P.L. 107-16, §542(e), expanded §684 to include a testamentary transfer after 2009 to a nonresident alien individual.
In place of the excise tax that applied to transfers to foreign corporations, a provision was added which provides that, to the extent provided in regulations, if a U.S. person transfers property to a foreign corporation as paid-in surplus or as a contribution to capital in a transaction not otherwise described in the rules regarding outbound transfers to foreign corporations (see ¶7130.07.A, above) (e.g., a capital contribution by a non-shareholder), the transfer is treated as a sale of such property for fair market value.497.2 Such a transferor must recognize as gain the excess of the fair market value of the property transferred over its adjusted basis.
497.2§367(f), effective Aug. 5, 1997. 
In place of the excise tax that applied to transfers to foreign partnerships, a provision was added which grants regulatory authority to the IRS to provide for gain recognition on a transfer of appreciated property to a partnership in cases where such gain otherwise would be transferred to a foreign partner.497.3
497.3§721(c), effective Aug. 5, 1997. See Regs. §1.6038B-2(h), which requires that a transferor who does not comply with the §6038B reporting requirements recognize gain as if the property had been sold for fair market value.
In place of the reporting rules for transfers of property by U.S. persons to foreign partnerships,497.4 new reporting rules were added for such transfers which are similar to the reporting rules for transfers of property to foreign corporations by U.S. persons.497.5 The reporting rules apply only if the U.S. person owns, directly or indirectly, at least a 10% interest in the partnership or if the value of the property transferred by the U.S. person during a 12-month period exceeds $100,000. Failure to comply with the reporting rules will result in a penalty equal to 10% of the fair market value of the property transferred and gain recognition with respect to the property (as if the property were sold for fair market value), however, the penalty cannot exceed $100,000 unless the failure was due to intentional disregard. The penalty under present law for failure to report transfers to a foreign corporation is conformed with this penalty, except that the gain recognition portion of the penalty does not apply.
497.4See the discussion of former §1494(c) at ¶7130.07.B.2, below. The Taxpayer Relief Act of 1997 provides that, at a taxpayer's election, former §1494(c) will not apply to any transfer after Aug. 20, 1996, if all the applicable reporting requirements of the new provision are satisfied. Taxpayer Relief Act of 1997, §1144(d)(2). See Notice 98-17, 1998-11 I.R.B. 6 (Procedures for relief from §1494 reporting for transfers made to foreign partnerships by satisfying the reporting requirements of §6038B, as amended by the Taxpayer Relief Act of 1997). 
497.5§6038B, as amended by the Taxpayer Relief Act of 1997. See Notice 98-17, 1998-11 I.R.B. 6 (Simplified rules for reporting transfers of property to foreign partnerships under §6038B after Aug. 5,1997 and before Jan. 1 1998), and Regs. §1.6038B-2, which replaces Notice 98-17 for transfers after 1997. Transfers to foreign partnerships are reported on Form 8865, Information Return of U.S. Persons with Respect to Certain Foreign Partnerships.
2. Pre-August 5, 1997 Rules
Prior to its repeal by the Taxpayer Relief Act of 1997, a separate regime imposed a 35% excise tax on any transfer of appreciated property by a U.S. citizen or resident, domestic corporation, partnership, trust or estate to a foreign corporation (as paid-in surplus or as a contribution to capital), or to a foreign partnership, trust or estate.497.6
497.6Former §1491-1494 (Subtitle A, Chapter 5 of the Code), repealed August 5, 1997.
The amount subject to the 35% excise tax was the excess of the fair market value of the property transferred over the sum of:498
498Former §1491.
•  its adjusted basis in the hands of the transferor; plus
•  the amount of gain, if any, recognized to the transferor at the time of the transfer.
There were three exceptions to the 35% excise tax. The first exception provided that the 35% excise tax did not apply to transfers to an organization exempt from tax under part 1 of subchapter F of the Code, 499 other than a qualified pension, profit-sharing or stock bonus plan.500
499I.e., §§501- 505.
500Former §1492(1). See §401(a).
The second exception provided that the 35% excise tax did not apply to transfers covered by the rules governing transfers to foreign corporations. 501 If a transfer was not covered by the rules governing transfers to foreign corporations, the transferor could avoid the 35% excise tax by electing (before the transfer) to apply principles similar to the rules governing transfers to foreign corporations. 502
501Former §1492(2)(A). The rules governing transfers to foreign corporations are contained in §367. The rules of §367 are discussed at ¶7130.07.A, above.
502Former §1492(2)(B). If the transferor did not make the election before the transfer, relief could be granted at the IRS' discretion if the transferor made the election after the transfer. See former §1494(b).
Under the third exception, the transferor could elect503 to treat the transfer as a sale or exchange, and to recognize as gain the excess of the fair market value of the property transferred over its adjusted basis.504
503Under former §1057, which was also repealed by the Taxpayer Relief Act of 1997, effective August 5, 1997.
504Former §1492(3).
The 35% excise tax was due and payable by the transferor at the time of the transfer.505  The transferor had to file Form 926 to report the transfer.506 The form was filed with the district director with jurisdiction over the transferor's income tax return. If the transferor relied on the exception to the 35% excise tax for transfers to certain exempt organizations, the transferor had to include an exemption certificate (or exemption ruling) with the form.507
505Former §1494(a); former Regs. §1.1494-1(a).
506Former Regs. §1.1494-1(a).
507Former Regs. §1.1494-1(b).
The Small Business Job Protection Act of 1996 added a penalty for the failure to file a return required by the IRS with respect to a transfer described above (i.e., by a U.S. citizen, resident, corporation, partnership, trust or estate to a foreign corporation (as paid-in surplus or as a contribution to capital) or to a foreign partnership, trust or estate). 508 A person required to file such a return who failed to do so was liable for penalties as if such failure were a failure to file a notice with respect to foreign trusts.509 This penalty was in addition to the 35% excise tax described above. The penalty was subject to a reasonable cause exception, which provided that no penalty would be imposed if the failure to file the return was due to reasonable cause and not willful neglect.510
508Former §1494(c). This penalty applied to transfers after August 20, 1996. As part of the repeal of §1494(c) by the Taxpayer Relief Act of 1997, new reporting requirements were enacted for transfers of property by U.S. persons to foreign partnerships comparable to information reporting for such transfers to foreign corporations under §6038B. See the amendments made to §6038B, discussed at ¶7130.07.B.1, above. The Taxpayer Relief Act of 1997 provides that, at a taxpayer's election, former §1494(c) will not apply to any transfer after August 20, 1996, if all the applicable reporting requirements of amended §6038B are satisfied. Taxpayer Relief Act of 1997, §1144(d)(2). See Notice 98-17, 1998-11 I.R.B. 6, fns. 497.4 and 497.5 and accompanying text, above.
509See former §1494(c). The notice provisions with respect to foreign trusts are contained in §6048(a), and the penalty provisions for the failure to provide such notice are contained in §6677. See ¶3830.13.C, above, for further discussion of these provisions. 
In general, if a timely, complete and correct notice required by §6048(a) is not filed, §6677 imposes a penalty which equals 35% of the "gross reportable amount" (generally the gross value of the property involved in the event, e.g., a transfer to a foreign trust, determined on the date of the event). If the failure continues for more than 90 days after the IRS mails notice to the taxpayer of the failure, the penalty is increased by $10,000 for each 30-day period following the end of the 90-day post-notification period, until the failure is remedied or until the total penalty equals the gross reportable amount.
510Former §1494(c); §6677(d). The fact that a foreign jurisdiction would impose a civil or criminal penalty on the taxpayer (or any other person) for disclosing the required information is not reasonable cause. §6677(d).
The IRS issued guidance regarding the penalty provision in  Notice 97-18.511  Notice 97-18 provides that a U.S. transferor is required to report a transfer described above only if it would be reportable under Notice 97-18.
5111997-10 I.R.B. 35 (3/10/97).
Notice 97-18 provides that a U.S. transferor  is not required to report a transfer described above if: (1) the U.S. transferor  immediately recognizes gain (if any) on the transfer equal to the difference  between the fair market value of the property and the U.S. transferor's adjusted  basis in such property; and (2) the U.S. transferor does not have a significant  interest in the transferee immediately after the transfer.512 Special rules are provided for determining whether these two requirements are  satisfied.513
512Notice 97-18, §II.A.
513Notice 97-18,  §II.A.1 and 2.
A U.S. transferor otherwise required to report a transfer described above  will generally be deemed to have satisfied the reporting requirement without  having to file Form 926 if the transferor complies with the  reporting requirements for transactions with certain foreign corporations, 514 transactions with certain  foreign-owned corporations,515 certain  transactions involving foreign corporations,516 or transactions with foreign  trusts.517
514Notice 97-18, §II.B.1;  §6038.
515Notice 97-18,  §II.B.2; §6038A. 
516Notice  97-18, §II.B.3; §§367  and 6038B.
517Notice 97-18, §II.B.4;  §6048.
Notice 97-18 also contains changes to the time and  manner for reporting transfers described above. In general, the notice provides  that a U.S. transferor may either file Form 926 with the U.S.  transferor's annual tax return or information return for the tax year that  includes the date of the transfer or may file Form 926 on the  day the transfer is made.518 Payment of the 35% excise  tax may also be made at either of such times; however, an interest charge is  levied if payment is not made on the day of the transfer.519 Special rules are  provided when an election to apply principles similar to the rules governing  transfers to foreign corporations or an election to treat the transfer as a  taxable exchange is made to avoid the 35% excise tax.520 The rules  for reporting transfers described above on Form 926 provide that  appreciated property (if the full amount of gain is not recognized on the  transfer) must be separately identified, while the value of other property may  be aggregated by category.521
518Notice  97-18, §III.A. See also Notice  97-18, §IV, Ex. 3.
519Notice 97-18, §III.D.
520 Notice 97-18, §III.B. See also Notice 97-18, §IV, Exs. 3 and 5. See Notice 97-42, 1997-29 I.R.B. 12, which extends the time during which these types of transfers may be reported if such transfer occurred for the tax year that includes August 20, 1996.
521Notice 97-18,  §III.C. See also Notice 97-18,  §IV, Exs. 3 and 4.
Notice 97-18 provides special rules for transfers  to certain foreign partnerships and for certain distributions from corporations  and partnerships. The notice provides that a transfer to a foreign partnership  with a valid election in effect to not be treated as a partnership will not  be considered a transfer to that foreign partnership for purposes of the 35%  excise tax or the reporting provisions.522 In addition, the notice states that notwithstanding any other provision of the  notice, until further guidance is issued taxpayers are not required to report  certain corporate or partnership distributions whether or not they constitute  transfers otherwise subject to reporting.523
522Notice  97-18, §VI. The election not to be treated as a partnership is contained in §761(a).
523Notice  97-18, §VII. The corporate distributions not  required to be reported are those described in §301,  §302 or §305,  while the partnership distributions not required to be reported are those  described in §731. Id.
Notice 97-18 is effective for transfers of property  occurring after August 20, 1996. No penalties will be imposed if a Form  926 reporting the transfers described above (or other adequate  reporting under another Code section, as described above) is filed by the due  date of the U.S. transferor's income tax return, including extensions, for the  taxable year in which the transfer occurred, or the date that is 60 days after  the date this notice is published in the Internal Revenue Bulletin (March 10,  1997), whichever is later.
¶7130.08
Liquidations of Foreign Corporations and Other Inbound Transfers
In general, nonrecognition applies if the organization, reorganization or liquidation of a foreign corporation does not involve the transfer of property from a U.S. person to a foreign person.524  But in those kinds of corporate realignments nonrecognition can permit avoidance of U.S. tax on the earnings of a foreign corporation, or removal of unrecognized asset appreciation from the U.S. tax base.
524§367(b). 
To the extent that corporate restructurings do not entail the possibility of tax avoidance, they are monitored only to ensure the taxpayer properly maintains earnings and profits accounts and determines asset bases. However, if there is a chance that a U.S. person will ultimately escape U.S. tax on the income of his foreign corporation, a toll charge is imposed on the U.S. taxpayer to prevent tax avoidance. In general, the toll charge causes the U.S. person to bring into income an equivalent to his share of the foreign corporation's earnings and profits. The following transactions are among the inbound transactions that attract that sort of income inclusion:
•   liquidations of foreign subsidiaries into a U.S. corporate parent; 525
•   acquisitive reorganizations in which the foreign corporation (or its assets) is acquired by a U.S. corporation;526
•   reorganizations that involve only foreign corporations in which a U.S. shareholder receives stock in a noncontrolled foreign corporation, or in which the U.S. shareholder loses its status as such;527
•   contributions of assets from one foreign corporation to another where either the recipient of the assets is not a controlled foreign corporation or any U.S. shareholder of the transferor will not be a U.S. shareholder in the transferee;528  and
•   a divisive reorganization in which a foreign corporation distributes stock to its U.S. shareholders and the stock distributed is that of either a U.S. corporation, or a foreign corporation that is not a controlled foreign corporation for Subpart F purposes or one as to which a U.S. person is not a U.S. shareholder.529
525§332, §367(b); Regs.§1.367(b)-3. See PLR 9523020.
526§367(b) and §368(a)(1)(B), (C), (D), (F); Regs. §1.367(b)-3. See PLR 9523020 and FSA 200106004 (Portion of distributions not disregarded as part of "circle of cash" in nine-step reorganization of affiliated group of corporations including foreign and domestic entities).
527§367(b) and §368(a)(1)(B), (C), (D) (nondivisive); Regs. §1.367(b)-4. 
528§367(b) and §351; Regs. §1.367(b)-4. 
529§367(b) and §355; Regs. §1.367(b)-5. 
¶7130.09
Reorganizations of Foreign Corporations and Other Foreign-to-Foreign Transfers
Certain transactions are foreign in their entirety and have no current impact on U.S. persons. As to those events, for U.S. tax purposes, only earnings and profits of the affected foreign entities are adjusted in order to allow for future recognition of income when an appropriate triggering event occurs. The U.S. person has no current income inclusion but eventually may be required to include an amount in income based on earnings and profits of the foreign entity recomputed to take the foreign-to-foreign transaction properly into account. Those transactions include:
•   liquidation of a foreign subsidiary into its foreign parent; 530
•   acquisition of assets or stock of a foreign corporation by another foreign corporation in a corporate reorganization, provided it is not an inbound transaction described above;531
•   capital contributions of assets from one foreign corporation to another, provided it is not an inbound transaction described above;532  and
•   divisive reorganizations in which a foreign corporation distributes stock to its shareholders, provided it is not an inbound transaction described above. 533
As noted above, in the transactions just described earnings and profits of the appropriate foreign corporations, for purposes of the affected U.S. person, are adjusted to allow for future recognition of the income.534
530§332, §367(b). See  Notice 87-5, 1987-1 C.B. 416, addressing the result to the liquidating corporation under §337 and §367(e)(2). 
531§367(b) and §368(a)(1)(B), (C), (D) (nondivisive); Regs.§1.367(b)-4. 
532§351, §367(b); Regs. §1.367(b)-4. 
533§355, §367(b); Regs. §1.367(b)-5. 
534 See Regs. §1.367(b)-4. For earnings and profits carryovers in foreign reorganizations, see the proposed regulations in REG-116050-99, 65 Fed. Reg. 69137 (11/15/00).
¶7130.10
Other Transfers and Similar Events Involving Foreign Persons
¶7130.10.A. Indirect Transfers in Domestic Corporate Reorganizations
Even when property is transferred from one domestic corporation to another, a reversal of the nonrecognition rules may occur if a foreign corporation is involved.535  For example, if a reorganization entails the merger of two U.S. corporations and the stock of a foreign corporation that controls one of the domestic corporations is included in the exchange, the transaction is treated as if the U.S. shareholder of the domestic corporation had made an indirect transfer of the foreign corporation's stock.536
535 Specially, if the transaction is triangular (A), (B), or (C) reorganization or a reverse triangular (A) reorganization. See ¶4910 for a discussion of these transactions.
536 Regs. §1.367(a)-1T(c). 
¶7130.10.B. Termination of Foreign Corporation's Election To Be Treated as a Domestic Corporation
A contiguous country corporation can elect in certain circumstances to be treated as a domestic corporation, mainly for purposes of filing a consolidated return with its U.S. parent.537 When the election is terminated, the event is treated as if a reorganization had occurred that involves the transfer of property from the U.S. corporation to its foreign subsidiary. The outbound rules, outlined above, apply.538
537§1504(d). Notice 2000-7, 2000-4 I.R.B. 419 (Guidance on the effect of the repeal of certain Canadian banking legislation on §1504(d) elections); Rev. Rul. 2001-39, 2001-33 I.R.B. 125 (Revocation of Rev. Rul. 70-379, 1970-2 C.B. 179, because Mexican law now allows U.S. corporations to own Mexican real estate).
538 Regs. §1.367(a)-1T(c)(5). See FSA 200221017 (Termination of §1504(d) election through issuance of preferred stock to unrelated bank resulted in deemed reorganization of foreign subsidiary under Regs. §1.367(a)-1T(c)(5)).
¶7130.10.C. Transfers Involving Partnerships
A U.S. partner in a domestic or foreign partnership who transfers his partnership interest in a transaction that would receive nonrecognition treatment under general Code rules is treated as having transferred his proportionate share of the partnership property if the transaction involves a foreign corporation. As a result, the nonrecognition rules do not apply, and the U.S. partner may recognize gain. The exception for active trade or business property, described above, is applied to the partnership property rather than to the partnership.539
539 Regs. §1.367(a)-1T(c)(3)(i)(B). If the partner is a limited partner in a partnership the interests of which are regularly traded on an exchange, the transfer is treated as if the partnership interest were stock or securities, and the partnership assets are disregarded. Regs. §1.367(a)-1T(c)(3)(ii)(C).
If a domestic or foreign partnership transfers property to a foreign corporation, its U.S. partners are treated as having transferred their proportionate share of the underlying partnership property. The tax effects to the partner are mainly governed by the partnership rules of the Code in conjunction with those described in ¶7130.07, above.540
540Regs. §1.367(a)-1T(c)(3)(i).
¶7130.10.D. Transfers Involving Trusts and Estates
For purposes of the reversal of the nonrecognition rules in outbound transactions the transfer of property by a trust or estate is treated as made by the entity itself instead of indirectly by its beneficiaries. As a result, it is of no consequence whether the beneficiaries are U.S. or foreign persons. Thus, no transfer by a foreign estate or trust is affected by the nonrecognition reversal rules, while transfers by U.S. trusts and estates are subject to them.541 
541Regs. §1.367(a)-1T(c)(4). 
The IRS has also ruled, in an inbound transaction, that the domestication of a foreign trust and the change in status from a foreign grantor trust to a domestic nongrantor trust: (1) will not cause a gain recognition event; (2) will not give rise to a gift, nor will future distributions from the trust be subject to gift tax; and (3) will not cause the generation-skipping transfer tax to apply to distributions and terminations of the trust.541.1 
541.1PLR 200338015 (referencing §§684(a), 2501, and 2601).
¶7130.11
Foreign Currency Transactions and Translation of Earnings 
¶7130.11.A. In General
For U.S. tax purposes, foreign currency is treated as property, not money. As a result, its purchase, sale or exchange has the potential for gain or loss realization and recognition. Because the exchange of a foreign currency is an exchange of property, the amount realized is measured by fair market value.
U.S. tax liability and its component parts (items of gross income, gains, losses, deductions, credits and so forth) are determined in U.S. dollars. Foreign currency exchange rates, as to the U.S. dollar and among each other, are mercurial. To conform to U.S. federal tax concepts, it is necessary to identify when currency translation to U.S. dollars is necessary, and to identify the tax effects of that translation.
Foreign currency translation questions arise in three contexts:
•   discrete transactions in foreign currency itself,  i.e., its spot purchase and sale not connected with a trade or  business or investment, and the sale, purchase or exchange of forward currency contracts;
•   operation of a directly owned foreign business  (e.g., a proprietorship or a branch) where the operations of the  business are continuous and carried on in a non-U.S. currency, but must  eventually be translated into U.S. dollars for U.S. tax purposes; and
•   indirect interests in foreign currency denominated items or transactions, e.g., a U.S. shareholder's interest in a foreign corporation's foreign-currency denominated earnings and profits for dividend purposes or its foreign taxes paid for foreign tax credit purposes.
In addition, there are source issues (what is the geographic source of currency gains and losses?), and characterization issues, both transactional (is currency fluctuation an interest equivalent?) and Code-oriented (is the gain or loss capital or ordinary?).
The Code establishes several statutory concepts to deal with transactions involving foreign currency. They apply, as appropriate, to both U.S. and foreign persons.
The starting point is the determination of the taxpayer's "functional currency." That determination is made with respect to each of the taxpayer's "qualified business units."
The Code creates a presumption that a taxpayer's functional currency is the U.S. dollar.542  If the taxpayer has a qualified business unit, the functional currency for that unit is the "currency of the economic environment" in which a significant part of the unit's activities are conducted and which is used by the unit in keeping its books.543  Notwithstanding that, the unit's functional currency is the dollar if its activities are primarily conducted in dollars.544  In addition, a qualified business unit can elect the dollar as its functional currency if it keeps its books and records in dollars and uses a method of accounting that approximates a separate transaction method. 545
542§985(b)(1)(A). 
543§985(b)(1)(B). See PLR 199947030. 
544§985(b)(2). 
545§985(b)(3). Cf. Regs. §1.985-1(b)(2)(ii)(A) (generally requiring use of dollar as functional currency if QBU otherwise would have a hyperinflationary currency as its functional currency).
A qualified business unit is a "separate and clearly identified unit" of a trade or business of a taxpayer which maintains separate books and records. 546   A corporation is a qualified business unit, but depending on its activities and method of keeping its books, a corporation may have separate business units (as can other kinds of taxpayers).547  As a result, it may have different functional currencies. An individual is not himself a qualified business unit. However, his activities can be a separate qualified business unit if they meet the tests of a separate trade or business attended by a complete and separate set of books and records. 548
546§989(a). 
547 Regs. §1.989(a)-1(b)(2). 
548 Regs. §1.989(a)-1(b)(3). 
A qualified business unit may change its functional currency, but it must then recognize gain or loss on the conversion and make appropriate adjustments to the basis of its assets and earnings and profits.  548.1
548.1Regs. §1.985-5.  Under Regs. §1.985-8T, the conversion of a legacy currency to the euro currency is a change in functional currency, but it is not necessary to recognize gain or loss.
¶7130.11.B. Transactions in Nonfunctional Currency
Where the taxpayer uses the U.S. dollar as the functional currency, income or loss from his dealings in foreign currency is measured in U.S. dollars as to each transaction. If the taxpayer uses foreign currency as his functional currency for a qualified business unit, income or loss from the unit is determined in the functional currency of the unit and is not translated into U.S. dollars until a translation event occurs. The Code deals directly with several specific types of transactions in which the amount to be paid or received by the taxpayer is either denominated in a nonfunctional currency or is determined by reference to the value of such a currency.549 They include:
•  acquisition of a debt instrument or becoming the obligor under a debt instrument;549.1
•  accruing or otherwise taking into account an item of gross income or expense that is to be paid on a later date, such as a trade receivable or payable; 549.2
•  entering into or acquiring a forward contract, option or similar financial instrument based on a currency, not an underlying commodity, that is not subject to a mark-to-market rule;550 and
•  the disposition of nonfunctional currency.551
549§988(c)(1)(A). See FSA 200149017 (Inventory purchases at U.S. dollar prices determined by reference to historical foreign currency values are subject to §988).
549.1Prop. Regs. §1.988-6, REG-106486-98, 68 Fed. Reg. 51944 (8/29/03).
549.2§988(c)(1)(B)(ii); FSA 200004006 (Expense denominated in a foreign currency is translated at the spot rate on the day the expense is accrued, rather than at the spot rate at the end of the taxable year).
550§988(c)(1)(B).
551§988(c)(1)(C)(i). Nonfunctional currency for this purpose includes demand or time deposits and other similar accounts or instruments issued by a bank or financial institution with amounts denominated in nonfunctional currency. §988(c)(1)(C)(ii).
In general, foreign currency gain or loss on those transactions is realized by virtue of a change in the exchange rates of the functional and nonfunctional currencies between the time the asset is first accounted for for tax purposes (termed the "booking date") and the time it is paid or otherwise disposed of. The gain or loss generally is ordinary, not capital, and its source is the residence of the taxpayer or his qualified business unit on the books of which the item appears.552
552§988(a). A number of exceptions and special rules are provided.
Firms engaging in discrete overseas transactions may be exposed, as well, to currency conversion tax consequences that are outside the purview of the §988 functional/nonfunctional currency regime.553
553In CCA 200303021, for example, residents of a foreign country on several occasions contributed local currency for stock of a locally organized corporation (presumably §351 transfers) and subsequently exchanged that stock for stock of a U.S. corporation in a tax-free reorganization; the Chief Counsel's Office without referring to §§985-989 advised that the U.S. corporation's U.S. tax basis in the acquired stock would be determined based on the U.S. dollar value of the foreign currency on the dates it was contributed to the foreign corporation, not on the basis of the exchange rate in effect at the time of the reorganization exchange. In G.M. Trading Corp. v. Comr., 103 T.C. 59 (1994), reconsidered, 106 T.C. 257 (1996), rev'd, 121 F.3d 977 (5th Cir. 1997), for example, the Tax Court followed the IRS position, holding that a Texas corporation realized a taxable gain by redeeming, in a debt-equity swap, dollar-denominated Mexican government debt in exchange for pesos restricted to the construction of an industrial plant in Mexico. The Fifth Circuit rejected the IRS's argument and reversed the Tax Court, holding that the taxpayer realized no gain on the transaction because any value of the restricted pesos in excess of the dollar-denominated debt was a non-taxable contribution to capital under §118(a). See Norwest Corp. v. Comr., 108 T.C. 265 (1997) (taxpayer realized loss on conversion of its Brazilian Central Bank  deposits, blocked from repatriation, into equity of Brazilian corporation, where Taxpayer received foreign currency equal in value to its basis in deposits). See also FSA 200123008 (domestic corporation should recognize gain when its foreign subsidiary receives restricted foreign currency after the parent pays U.S. dollars to retire debt of foreign country's government). Contrast FSA 199904012 (In different circuit but otherwise similar facts to G.M. Trading Corp. v. Comr., discussed above, IRS National Office indicates agreement with Tax Court in that case, despite reversal, and also suggests §367(a) supports this conclusion) with CMI International, Inc. v. Comr., 113 T.C. 1 (1999) (no gain recognition under §367(a) on Michigan corporation's debt-equity swap with its Mexican subsidiary because sale of debt would not have produced gain as required by Regs. §1.367(a)-1T(b)(3)(i)).
For individuals the foregoing rules apply only to transactions related to a trade or business or to the production or collection of income. 554 They do not apply to personal transactions. For example, §988(e), as amended by the 1997 TRA, provides that for taxable years beginning after 1997, an individual acquiring and disposing of foreign currency in a personal transaction does not recognize exchange gain, to the extent that gain does not exceed $200. The conference report clarifies that personal transactions entered into in conjunction with a business trip constitute personal transactions within the meaning of amended §988(e). 
554§988(e). That is, transactions the expenses of which would be deductible by the individual under §162 or §212 (other than expenses incurred in  connection with the determination, collection or refund of taxes). See Rev. Rul. 90-79, 1990-2 C.B. 187.
If the economic substance of a nonfunctional currency transaction differs from its form, the timing, source, and character of the income or loss may be characterized in accordance with its substance.554.1 
554.1Regs. §1.988-2(f). See also FSA 200206006 (artificial currency loss created in otherwise valid §351 transfer disallowed under Regs. §1.988-2(f) because loss reflects basis shifting, not currency fluctuations); CCA 200237003 (currency loss created through §351 transfer could be disallowed as tax sham, basis created in currency was 1000 times greater that its fair market value; IRS also has authority under Regs. §1.988-1(a)(11) to recharacterize any such loss recognized as capital loss).
¶7130.11.C. Translation of Income and Foreign Taxes Paid
A U.S. taxpayer with foreign operations in the form of an unincorporated branch (that is a qualified business unit) or in the form of a foreign subsidiary must translate their nonfunctional foreign currency accounts into dollars at certain points in time appropriate for federal tax purposes. In addition, a taxpayer is required to translate foreign taxes paid into dollars to claim the foreign tax credit (or a deduction for those taxes).
If a foreign branch has a functional currency other than the dollar, its income or loss is first computed in its functional currency. The result is translated to U.S. dollars using a weighted average exchange rate for the taxable period over which the income or loss was derived. That amount is included in the U.S. taxpayer's income without regard in the first instance for remittances actually made from the branch during the taxable period. The actual remittance from the branch (of money or property) is treated as a taxable event as to which gain or loss is separately computed to the extent that the value of the currency when remitted differs from the value when earned.555
555§987. In Notice 2000-20, 2000-14 I.R.B. 851, the IRS advised that it is considering replacing the existing proposed regulations under §987 and solicits comments thereon and that new regulations (effective March 21, 2000) will attack circular and other tax-motivated property transfers designed to generate artificial exchange losses.
To determine the tax of any shareholder (whether a U.S. or a foreign person) of a foreign corporation, the corporation's earnings and profits are first determined in the corporation functional currency. Deemed distributions under Code provisions that require income inclusion in the hands of a U.S. shareholder without an actual distribution have various methods for determining the proper exchange rates.556 Where the foreign corporation's earnings and profits are actually distributed, the U.S. taxpayer must translate the amount at the current exchange rate on the distribution date.557
556§986(b), §989(b). See TAM 200141003 (In context of a §304(a)(1) redemption transaction, taxable portion of distribution is translated into U.S. dollars at spot rate per §989(b)(1); exchange gain attributable to previously taxed earnings (PTI) distribution is recognized under §986(c) based on movement of exchange rates between time of previous inclusion in income and actual distribution of PTI).
557§989(b)(1). 
Foreign taxes paid directly by a U.S. taxpayer in foreign currency are translated to U.S. dollars at the exchange rate in effect on the date of payment to the foreign taxing authority. If a later adjustment to the foreign taxes owed results in the payment of a deficiency, the exchange rate on the date of the additional payment is used. But if an adjustment results in a refund or credit of the foreign taxes, the amount is translated at the exchange rate applicable at the time the taxes were originally paid.558  Foreign taxes as to which a U.S. corporate taxpayer can claim a credit as taxes deemed paid are translated at the exchange rate applicable on the date the taxes are paid by the foreign corporation.559
558§986(a). 
559§986(a)(1)(A). 
¶7130.11.D. Blocked Foreign Income
If a taxpayer has foreign income that cannot be converted into U.S. dollars he may elect to defer reporting it. To qualify for the elective treatment the income cannot be readily convertible into dollars, or into other foreign income or property due to exchange, monetary or other restrictions imposed by a foreign government with control over the income. The fact that the foreign income can only be converted at a highly unfavorable rate is not enough to qualify for deferral.560
560 See Rev. Rul. 74-351, 1974-2 C.B. 144. 
If a controlled foreign corporation has blocked income that could not actually be distributed to its U.S. shareholders because of foreign government restrictions, its earnings and profits for Subpart F purposes do not include that income. Certain statutory qualifications must be met before the corporation can exclude the blocked income from its earnings and profits. 561
561§964(b); Regs. §1.964-2. 
If the taxpayer elects to defer the inclusion of blocked income, expenses and deductions associated with the income are also deferred.
After deferral, the blocked income is includible in gross income in the year in which it is first used by the taxpayer for personal expenses, or he transfers the right to the income, or the foreign government lifts the ban on its use, or the taxpayer actually receives payment of the blocked income notwithstanding the fact that the blockage continues. When the income is freed up under one of those alternatives, the taxpayer includes it in income at the rate of exchange that exists at that time.562
562 See Rev. Rul. 74-351, 1974-2 C.B. 144. 
¶7130.12
Restrictions on Foreign Activities
¶7130.12.A. Boycott Participation Penalties
The Internal Revenue Code discourages taxpayers from participating in international boycotts or doing business with countries that embrace or support international boycotts. The disincentives take several forms.
Detailed information returns must be filed to report transactions undertaken in relation to a boycotting foreign country. They are required if a person actually participates in an international boycott transaction, or if he engages in a direct or indirect transaction with or in a boycotting country. Willful failure to report is a felony punishable by fine and imprisonment. 563
563§999. 
In addition, participation in or cooperation with an international boycott may result in a denial of the foreign tax credit for foreign taxes paid on boycott income,564  the benefits of treatment as a foreign sales corporation or a domestic international sales corporation may be diminished,565  and the Subpart F income of a controlled foreign corporation may be increased.566
564§908. A deduction for those taxes is not affected. 
565§927(c)(2), §995(b)(1)(F)(ii). 
566§952(a)(3). 
¶7130.12.B. Foreign Bribes and Kickbacks
A bribe, kickback or other payment to a foreign government official is illegal if it violates the Foreign Corrupt Practices Act of 1977.567  Only payments to foreign government officials that are made to influence official action in order to obtain business are illegal. Payments made to those officials to facilitate administrative action (so-called "grease" payments), or bribes and kickbacks made to nongovernmental persons are not within the prohibition.
567§162(c)(2). 
Several results occur if proscribed payments are made:
•   the amounts are not deductible as a business expense;568
•   they limit the benefits available under the foreign sales corporation 569   and domestic international sales corporation570  provisions;
•   they increase a controlled foreign corporation's Subpart F income; 571   and
•   they cannot be used to decrease its earnings and profits.572 
568§162(c)(1). 
569§927(e)(2). 
570§995(b)(1)(F)(iii). 
571§954(a)(2). 
572§964(a). 
———— PRACTICE AIDS ————
¶7130.100 Client Letter 
Exclusions for Citizens and Residents Employed Abroad
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This letter is to remind you of our upcoming meeting and to give you some background information so that we may discuss your tax situation more constructively when we meet.
You told me that you are an airline pilot for a U.S. airline and that you earned income from flying abroad. You reside overseas. You are inquiring as to whether you may exclude, for U.S. tax purposes, any of the income you earned while working abroad throughout the year. You also wonder whether you may exclude other expenses which you incurred or which were paid on your behalf by your employer while flying abroad. The following is a general summary of the rules for excluding income earned and costs paid on your behalf while you were abroad.
Types of Exclusions:
Qualifying individuals are entitled to different types of exclusions under the tax law against income received while working abroad. Among these are the following: (i) a foreign earned income exclusion; (ii) a housing cost amount exclusion; and (iii) an exclusion for employer-provided meals and lodging.
When you elect to exclude foreign earned income, in 2002  you may exclude up to $80,000 of foreign earned income annually, computed on a daily basis. This amount remains at $80,000 until 2008, when it becomes subject to an inflation adjustment. To determine the amount of your exclusion in any year, multiply the limit by a fraction the numerator of which is the number of days you were a qualified individual for purposes of the exclusion and the denominator of which is the number of days in the year. Thus, if you were a qualified individual (see below for discussion of this status) for 330 days in 2002 and you earned $200,000 during that year while flying abroad, you would be able to exclude $72,329 ($80,000 x 330/365) against the $200,000 that you earned (approximately $219.18 for each day you were a qualified individual).
The housing cost amount  exclusion is available only if the housing expenses are attributable to employer-provided amounts. If the amounts are not so attributable, you may deduct the expenses, subject to a limitation. The housing cost exclusion is equal to housing expenses less a "housing base amount." Included in the category of housing expenses are: rent, utilities, real and personal property insurance, occupancy taxes, nonrefundable fees paid for securing a leasehold, rental of furniture and accessories, residential parking, and repairs. Housing expenses include items you paid or incurred or that were paid or incurred for you for housing in a foreign country for yourself, your spouse, and your dependents. The housing base amount is 16% of the salary of a grade GS-14 Step 1 government employee multiplied by the number of days you qualified for an exclusion. 
A separate exclusion is provided for employer-provided meals and lodging  if certain requirements are met. For instance, the value of meals is excludable if they are provided on your employer's business premises for the employer's convenience. Furthermore, the value of employer-provided lodging is excludable if the lodging is furnished on your employer's business premises, it is furnished for the employer's convenience, and you are required to accept the lodging as a condition of employment. There is no dollar limit on this exclusion for employer-provided meals and lodging.
Qualification for Exclusions:
To qualify for the foreign earned income and housing cost exclusions, you must have a "tax home" in a foreign country and be either:
[1] a U.S. citizen and a "bona fide resident" of a foreign country or countries, for an  uninterrupted period of the entire taxable year; or
[2] a U.S. citizen or resident who is present in a foreign country, or countries, for 330 full  days during any period of 12 consecutive months under the "physical presence test."
Your "tax home" is considered to be located at your regular or principal (if more than one regular) place of business or, if you have no regular or principal place of business because of the nature of the business, at your regular place of abode. You must maintain your foreign tax home status for a minimum of 11 months throughout the year.
Generally, before you can be considered a bona fide resident of a foreign country, you must be physically present in the foreign country and have an intent to make a home in that country for an indefinite period of time.
If you do not satisfy the bona fide resident test, you may still qualify for the exclusions and deduction if you meet the "physical presence" test. Generally, this test is satisfied if you are present in a foreign country or countries for at least 330 full days of any 12-consecutive-month period.
Electing the Exclusions:
To take advantage of the foreign earned income and housing cost amount exclusions, you must make a separate election on Form 2555 or Form 2555-EZ with respect to each of the exclusions. The exclusion for employer-provided meals and lodging may be made without the necessity of an election. Once you make an election, it applies to all subsequent taxable years unless it is revoked. Each election must be filed either with an income tax return that is timely filed (including extensions of time to file), with a timely filed amended return, or with an original return filed within one year after the due date of the return (determined without regard to extensions).
The IRS has discretion, if you show good cause, to grant a reasonable extension of time to make an election. In determining whether it will allow a late election, the IRS considers factors such as your diligence and prompt action, and your intent.
¶7130.200 Client Letter 
Possession Tax Credit
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This letter is in response to your recent inquiry regarding the possessions tax credit. As an introduction for our upcoming meeting on this matter, this letter will provide a general outline of the how the credit works and qualification for the credit.
Introduction
The possessions tax credit is an incentive for U.S. companies to engage in a trade or business in U.S. possessions. The credit applies to all U.S. possessions including Puerto Rico and the Virgin Islands (the majority of possessions corporations are located in Puerto Rico). The credit is usually elected where a U.S. corporation establishes a domestic subsidiary for the purpose of engaging in business in Puerto Rico. The subsidiary elects the application of the possessions tax credit and manufactures products in Puerto Rico to sell to its parent or other U.S. affiliates for resale to unrelated persons. The possessions corporation is generally wholly or partially exempt from Puerto Rican income taxes.
The possessions tax credit comes in the form of a credit against a portion of the possessions corporation's U.S. tax liability attributable to a portion of taxable income from the conduct of an active trade or business within the possession and a portion certain income from investments in the possession.
Qualification
Whether XYZ qualifies for the credit is determined separately with respect  to each possession for which the credit is to be claimed. To be eligible for  a given possession, XYZ must have had a valid election in effect for that  possession as of October 13, 1995, and have been engaged in the active  conduct of a trade or business there. If the company had a binding contract  in effect on that date and began business before the end of 1995, it would  qualify as well.
It is significant to note that, if XYZ adds a substantial new line of  business, it will no longer be qualified for the credit, as of the end of the  year preceding the addition of the business. Thus, if you have any expansion  plans, they should be reviewed very carefully to ensure that the credit is  not jeopardized.
Amount of Credit
Before 1996, a credit was allowed for qualified possession source investment  income. As of July 1, 1996, however, this portion of the credit is no longer  available.
The other portion of the credit depends on the economic activity of the  corporation. It is measured by either the "wage credit method" or the  "income credit method." This portion of the credit is being phased out in  the manner described below.
For operations in Guam, American Samoa, and the Northern Mariana Islands,  the credit is fully available under the pre-1996 rules through 2005. After  that, it is eliminated.
For operations elsewhere, the credit under the income method is the same  as under the pre-1996 rules for 1996 and 1997. After that, the income used  to compute the credit is capped, essentially to the average of three of the  five most recent years. After 2005, the credit is eliminated.
If a corporation used the wage credit method before 1996, its credit is  computed the same way as before until 2001. From 2002 through 2005, it is  subject to a cap computed the same way as for the income method. This method  also is eliminated after 2005.
Revoking Income Method Election
XYZ has been using the elective income credit method of computing the  economic activity component of its credit. It may be advantageous to revoke  this election and begin using the wage credit method. The reason is that the  cap will not apply to the latter method until 2002, four years later than it  will apply to the income method. We should carefully go over XYZ's operations  and expectations to see if the election should be revoked. If so, that can be  done effective for 1997. If not revoked by then, it can never be revoked.
I hope this summary has proved useful. Please contact me with any further  questions, or to set up a meeting to review XYZ's income method election.