Rev. Rul. 81-50

                       Internal Revenue Service
                                 Revenue Ruling

            FOREIGN TAX CREDIT; LIMITATIONS EXCEEDING TAXABLE INCOME

                          Published: February 17, 1981

Section 904.--Limitation on Credit, 26 CFR 1.904-1: Limitation on credit for foreign taxes.

  Foreign tax credit; limitations exceeding taxable income. The proper method is shown for computing the foreign tax credit limitation described in section 904(a) of the Code in a situation in which a loss from domestic operations causes the sum of the foreign source taxable income amounts in the separate foreign tax credit limitations to exceed total taxable income from all sources.

ISSUE

  How must the foreign tax credit limitation provided in section 904(a) of the Internal Revenue Code be computed under the circumstances described below, when a loss from domestic operations causes the sum of the foreign source taxable income amounts in the separate foreign tax credit limitations to exceed total taxable income from all sources?

FACTS

  P, a domestic corporation, is engaged in the manufacturing and selling of commercial and industrial products both within and without the United States. In 1973, P organized a wholly owned domestic subsidiary, S, as a Domestic International Sales Corporation (DISC). S's income in each of its taxable years qualified as export receipts under section 993(a)(1) of the Code.

  For its 1979 taxable year, P sustained a loss from its domestic operations and, thus, did not have taxable income from sources within the United States for that taxable year. In the same taxable year, P had foreign source taxable income that exceeded P's domestic loss. P's foreign source taxable income consisted of dividends from its DISC, S, as described in section 861(a)(2)(D) (to the extent attributable to qualified export receipts) and other non-interest income P did not earn foreign oil related income in taxable year 1979. § paid foreign income taxes on its taxable income, and P paid foreign income taxes on its foreign source taxable income.

LAW AND ANALYSIS

  Section 861(a)(2)(D) and section 862(a)(2) of the Code provide that dividends from a DISC, to the extent attributable to certain qualified export receipts as defined in section 993(a)(1), are to be treated as income from sources without the United States (hereinafter 'section 904(d) dividends').

  Section 901(d) of the Code indicates that for purposes of sections 901 through 908, dividends from a DISC will be treated as dividends from a foreign corporation to the extent they are foreign source dividends under section 861(a)(2)(D) and 862(a)(2).

  Section 901(a) and (b)(1) of the Code permits a domestic corporation to claim a credit against federal income tax for any foreign income taxes paid or accrued or deemed to have been paid or accrued under section 902 during the taxable year to any foreign country, subject to the limitations of section 904 of the Code.

  Section 902(a) of the Code provides that a domestic corporation that owns at least 10 percent of the voting stock of a foreign corporation from which it receives dividends in any taxable year shall be deemed to have paid the same proportion of any income tax paid or deemed to have been paid by such foreign corporation to any foreign country, on or with respect to the accumulated profits of such foreign corporation from which such dividends were paid, which the amount of such dividends (determined without regard to section 78) bears to the amount of such accumulated profits in excess of such income taxes (other than those deemed paid).

  For purposes of section 902 of the Code, a DISC is treated as a foreign corporation, but only with respect to dividends from a DISC to the extent such dividends are foreign source dividends. See section 1.902-1(a)(2) of the Income Tax Regulations.

  Section 78 of the Code provides that an amount equal to the taxes deemed to be paid by a domestic corporation under section 902(a) shall be treated, for purposes other than section 245, as a dividend received from a foreign corporation by the domestic corporation.

  Section 861(b) of the Code and the Income Tax Regulations thereunder provide that the expenses, losses, and other deductions properly apportioned and allocated to items of gross income that are from sources within the United States shall be deducted from such items of gross income.

  Section 904(a) of the Code provides that the total amount of the credit taken under section 901(a) shall not exceed the same proportion of the tax against which such credit is taken which the taxpayer's taxable income from sources without the United States (but not in excess of the taxpayer's entire taxable income) bears to the taxpayer's entire taxable income for the same taxable year.

  Section 904(c) of the Code provides for the carryback and carryover of unused foreign taxes; that is, taxes eligible for credit during a taxable year that exceed the amount currently creditable for the year under the applicable section 904 limitation. Such taxes may be carried back two years and then carried forward five years to the extent that the tax first eligible for the credit in those years is less than the applicable limitation.

  Section 904(d)(1)(A), (B), and (C) of the Code provides, respectively, that section 904(a), (b), and (c) shall be applied separately to each of the following items of income: interest income described in section 904(d)(2), dividends from a DISC to the extent such dividends are treated as from sources without the United States (section 904(d) dividends), and foreign source taxable income other than that described in section 904(d)(1)(A) and (B). In addition, section 907(b) provides that section 904 is to be applied separately with respect to foreign oil related income.

  Section 1.904-5(a)(1)(iv) of the regulations interprets the former section 904(f) of the Code, renumbered as section 904(d) by the Tax Reform Act of 1976, Pub. L. 94-455 1976-3 C.B. (Vol. 1) 1, 97, as requiring the taxpayer to apply the overall limitation to all of its foreign source taxable income that is attributable to other income, and to apply a separate limitation computed in the same manner as the overall limitation to the aggregate of its section 904(d) dividends.

  Section 1.904-5(a)(1)(v) of the regulations provides that the separate limitation with respect to section 904(d) dividends shall be applied only with respect to foreign income taxes paid or accrued with respect to section 904(d) dividends. This includes those unused foreign taxes paid or accrued with respect to section 904(d) dividends that are deemed to be paid or accrued in a particular taxable year by virtue of the carryback or carry-forward provision of former section 904(d), renumbered as section 904(c) by the Tax Reform Act of 1976 supra.

  Section 1.904-5(b)(1) of the regulations indicates that unused foreign taxes paid or accrued with respect to section 904(d) dividends means the excess of (A) all the foreign income taxes paid or accrued (or deemed paid or accrued other than by reason of section 904(c) of the Code) in such year with respect to section 904(d) dividends, over (B) the separate limitation for such year with respect to such dividends.

  In the present case, P must make separate computations under section 904(d)(1)(B) and (C) of the Code, respectively, because P received section 904(d) dividends from § with respect to which P was deemed to have paid foreign income tax under section 902 and other foreign source taxable income. The denominator of the formula used in both computations is P's total taxable income. The numerator of the formula used in the section 904(d)(1)(C) computation is P's taxable income from sources without the United States, exclusive of the section 904(d) dividends from S. The numerator of the formula used in the section 904(d)(1)(B) computation is the section 904(d) dividends from S, plus the section 78 gross-up of the foreign income taxes deemed paid with respect to such dividends under section 902. See section 1.904-5(c) of the regulations (Example 1). P's foreign tax credit limitation for the taxable year 1979 is the sum of these separately computed limitations.

  As illustrated in the example below, the domestic loss that P sustained reduces the denominator of the limitation formulas (total taxable income) but does not affect the amount of foreign source section 904(d) dividends (plus the section 78 gross up) or the other foreign source taxable income because these amounts do not include taxable income from sources within the United States. Consequently, the aggregate of these amounts exceeds the denominator of the limitation. If such amounts were used in the numerators of the separate formulas used to compute the limitations, the aggregate of the separate foreign tax credit limitation would be greater than P's pre-credit United States tax. Such a result would be incorrect, however, because section 904(a) of the Code restricts the maximum credit limitation in a year to the pre-credit United States tax liability for that year. Section 904(a) of the Code states that '[t]he total amount of the credit taken under section 901(a) shall not exceed the same proportion of the tax against which such credit is taken which the taxpayer's taxable income from sources without the United States (but not in excess of the taxpayer's entire taxable income) bears to his entire taxable income for the same taxable year.' (Emphasis added). This parenthetical is designed to assure that the section 904(a) credit limitation does not exceed 100 percent of the United States tax for the taxable year.

  In requiring that the separate credit limitations be computed under section 904(d) of the Code for section 904(d) dividends and for other foreign source income, Congress did not intend to negate the above-quoted language in section 904(a) so as to increase the maximum credit allowable by permitting the use of amounts in the numerators of the separate credit limitation formulas that would produce, in the aggregate, a credit limitation in excess of the pre-credit United States tax.

  In order to give the proper effect to the parenthetical language of the foreign tax credit limitation under section 904(a), (c), and (d) of the Code when a domestic loss would result in the aggregate of the amount of foreign source taxable income in the separate limitation formulas producing a credit limitation in excess of the pre-credit United States tax, it is necessary to reduce proportionately the amounts of foreign source taxable income in the separate formulas. In such a case, the amount of foreign source taxable income in each formula should be reduced by the fraction that total foreign source taxable income (F.T.I.), minus taxable income (T.I.), bears to total foreign source taxable income (F.T.I.):

  The principles discussed in this revenue ruling are illustrated in the following examples:

    Assume that P had the income indicated below and paid the foreign taxes indicated below for its taxable year ending December 31, 1979.

                                                   Taxable Income    Foreign
                                                                    Taxes Paid
                                                                    or Deemed
                                                                       Paid
                                                   --------------  ------------
Section 904(d) dividends from § DISC ................ $10,000          $ 10,000
Gross-up under section 78 of foreign taxes deemed
  paid with respect to section 904(d) dividends ..... $ 10,000
Other foreign source income ......................... $400,000         $200,000
Loss from domestic operations ...................... ($110,000)
Total taxable income ................................ $400,000
Pre-credit United States tax ........................ $184,000
   Section 904(d)            X       x'8F Other foreign source    X Pre-credit
   dividends x'8F       Pre-credit      income/Total taxable        U.S. tax
     section 78          U.S. tax              income
    grossup/Total
   taxable income
  $110,000/$400,000    X 184,000 =    x'8F $400,000/$400,000X
                         $50,600        $184,000 = 184,000 =
                                              $234,000
Total limitation = $234,600 (exceeds the limit of $184,000)
($510,000 (F.T.I.)-$400,000 (T.I.))-$510,000 (F.T.I.)  =.2156862
$110,000 X .2156862 =
  $23,725.48
$400,000 X .2156862 =
  $86,274.48
$110,000 -                  x $184,000 =   Separate section 904 limitation with
  $23,725.48/$400,000        $39,686.28     respect to section 904(d) dividends
$400,000 -                  x $184,000 =    Section 904 limitation with respect
  $86,274.48/$400,000        $144,313.-         to other foreign-source taxable
                                 72                                      income
$39,686.28 x'8F              = $184,000    Total section 904 limitation (equals
  $144,313.72                                       the limitation of $184,000)
    After reducing the amounts in the numerators of the separate limitation formulas, P's foreign tax credit limitation with respect to section 904(d) dividends for 1979 is $39,686.38. Thus, in 1979, P may credit the entire $10,000 of taxes it was deemed to have paid under section 902(a) with respect to the section 904(d) dividends. P has no unused foreign taxes paid or accrued with respect to such dividends for 1979, but does have a $29,686.28 excess limitation with respect to such dividends for 1979 ($39,686.28-- $10,000). See section 1.904-5(b)(iii) and (v) of the regulations.
    P's foreign tax credit limitation with respect to its other foreign source taxable income for 1979, is $144,313.72. Thus, in 1979, P cas credit that amount. P also has unused foreign taxes for 1979 of $55,686.28 ($200,000--$144,313.72) that P may carry forward or backward under section 904(c) of the Code to taxable years in which it has an excess limitation with respect to other foreign source taxable income. See section 1.904-2(c)(2)(i) and (ii) of the regulations.
HOLDING
  When a domestic source loss causes the total amount of foreign source taxable income in the separate foreign tax credit limitations under section 904 of the Code to exceed total taxable income, the amount in the numerators of the separate limitation formulas must be reduced by the fraction that total foreign source taxable income, minus taxable income, bears to total foreign source taxable income. The reduced amount in each numerator of the separate limitation formulas must be used to compute the sum of the separate limitations that constitute the maximum limitation under section 904(a).

Rev. Rul. 81-50, 1981-1 C.B. 410, 1981-7 I.R.B. 11.