Reg. § 1.861-12 Characterization rules and adjustments for certain assets.
(a) In general The rules in this section apply to taxpayers apportioning expenses under an asset method to income in the various separate categories described in , and supplement other rules provided in through . The principles of the rules in this section also apply in apportioning expenses among statutory and residual groupings for any other operative section. See also for a rule requiring conformity of allocation methods and apportionment principles for all operative sections. of this section describes the treatment of inventories. of this section concerns the treatment of various stock assets. of this section describes a basis adjustment for stock in 10 percent owned corporations. of this section sets forth rules for characterizing the stock in controlled foreign corporations. of this section describes the treatment of stock of noncontrolled 10-percent owned foreign corporations. of this section concerns the treatment of notes. of this section concerns the treatment of notes of controlled foreign corporations. of this section describes the treatment of certain portfolio securities that constitute inventory or generate income primarily in the form of gains. of this section describes the treatment of assets that are funded by interest that is capitalized, deferred, or disallowed. of this section concerns the treatment of FSC stock and of assets of the related supplier generating foreign trade income. of this section concerns the treatment of DISC stock and of assets of the related supplier generating qualified export receipts.
(b) Inventories For further guidance, see .
(c) Treatment of stock
(1) In general For further guidance, see .
(2) Basis adjustment for stock in 10 percent owned corporations
(i) Taxpayers using the tax book value method
(A) General rule For purposes of apportioning expenses on the basis of the tax book value of assets, the adjusted basis of any stock in a 10 percent owned corporation owned by the taxpayer either directly or indirectly through a partnership or other pass-through entity (after taking into account the adjustments described in of this section) shall be—
(1) Increased by the amount of the earnings and profits of such corporation (and of lower-tier 10 percent owned corporations) attributable to such stock and accumulated during the period the taxpayer or other members of its affiliated group held 10 percent or more of such stock; or
(2) Reduced by any deficit in earnings and profits of such corporation (and of lower-tier 10 percent owned corporations) attributable to such stock for such period; or
(3) Zero, if after application of and of this section, the adjusted basis of the stock is less than zero.
(B) Computational rules
(1) Adjustments to basis
(i) Application of section 961 or 1293(d) For purposes of this section, a taxpayer's adjusted basis in the stock of a foreign corporation does not include any amount included in basis under section 961 or 1293(d) of the Code.
(ii) Application of section 965(b) For purposes of this section, if a taxpayer owned the stock of a specified foreign corporation (as defined in ) as of the close of the last taxable year of the specified foreign corporation that began before January 1, 2018, the taxpayer's adjusted basis in the stock of the specified foreign corporation for that taxable year and any subsequent taxable year is determined as if the taxpayer did not make the election described in (regardless of whether the election was actually made) and is further adjusted as described in this . If applied (or would have applied if the election had been made) with respect to the stock of a specified foreign corporation, the taxpayer's adjusted basis in the stock of the specified foreign corporation is reduced by the amount described in (without regard to the rule for limited basis adjustments in and the limitation in , and without regard to the rules regarding the netting of basis adjustments in ). The reduction in the taxpayer's adjusted basis in the stock may reduce the taxpayer's adjusted basis in the stock below zero prior to the application of and of this section. No adjustment is made in the taxpayer's adjusted basis in the stock of a specified foreign corporation for an amount described in . To the extent that, in an exchange described in section , , or , a taxpayer receives stock of a foreign corporation in exchange for stock of a specified foreign corporation described in this , this applies to such stock received.
(2) Amount of earnings and profits For purposes of this , earnings and profits (or deficits) are computed under the rules of section and, in the case of a foreign corporation, sections and for taxable years of the 10 percent owned corporation ending on or before the close of the taxable year of the taxpayer. Accordingly, the earnings and profits of a controlled foreign corporation include all earnings and profits described in section . The amount of the earnings and profits with respect to stock of a foreign corporation held by the taxpayer is determined according to the attribution principles of section and the regulations under section . The attribution principles of section apply without regard to the requirements of section that are not relevant to the determination of a shareholder's pro rata portion of earnings and profits, such as whether earnings and profits (or deficits) were derived (or incurred) during taxable years beginning before or after December 31, 1962.
(3) Annual noncumulative adjustment The adjustment required by of this section is made annually and is noncumulative. Thus, the adjusted basis of the stock (determined without regard to prior years' adjustments under of this section) is adjusted annually by the amount of accumulated earnings and profits (or deficits) attributable to the stock as of the end of each year.
(4) Translation of non-dollar functional currency earnings and profits Earnings and profits (or deficits) of a qualified business unit that has a functional currency other than the dollar must be computed under this in functional currency and translated into dollars using the exchange rate at the end of the taxpayer's current taxable year (and not the exchange rates for the years in which the earnings and profits or deficits were derived or incurred).
(C) Examples The following examples illustrate the application of of this section.
(1) Example 1: No election described in § 1.965-2(f)(2)(i)
(i) Facts USP, a domestic corporation, owns all of the stock of CFC1 and CFC2, both controlled foreign corporations. USP, CFC1, and CFC2 all use the calendar year as their U.S. taxable year. USP owned CFC1 and CFC2 as of December 31, 2017, and CFC1 and CFC2 were specified foreign corporations with respect to USP. USP's basis in each share of stock of each of CFC1 and CFC2 is identical. USP did not make the election described in , but if USP had made the election, would have applied to the stock of CFC2 and the amount described in (without regard to the rule for limited basis adjustments in and without regard to the rules regarding the netting of basis adjustments in ) with respect to the stock of CFC2, in aggregate, is $75x. For purposes of determining the value of the stock of CFC1 and CFC2 at the beginning of the 2019 taxable year, without regard to amounts included in basis under section or , USP's adjusted basis in the stock of CFC1 is $100x and its adjusted basis in the stock of CFC2 is $350x (before the application of of this section).
(ii) Analysis Under of this section, USP's adjusted basis in the stock of CFC1 is determined as if USP did not make the election described in . USP's adjusted basis in the stock of CFC2 is then reduced by $75x, the amount described in , without regard to the rule for limited basis adjustments in and without regard to the rules regarding the netting of basis adjustments in . No adjustment is made to USP's adjusted basis in the stock in CFC1. Accordingly, for purposes of determining the value of stock of CFC1 and CFC2 at the beginning of the 2019 taxable year, USP's adjusted basis in the stock of CFC1 is $100x and USP's adjusted basis in the stock of CFC2 is $275x ($350x−$75x).
(2) Example 2: Election described in § 1.965-2(f)(2)(i)
(i) Facts USP, a domestic corporation, owns all of the stock of CFC1, which owns all of the stock of CFC2, both controlled foreign corporations. USP, CFC1, and CFC2 all use the calendar year as their U.S. taxable year. USP owned CFC1, and CFC1 owned CFC2 as of December 31, 2017, and CFC1 and CFC2 were specified foreign corporations with respect to USP. USP's basis in each share of stock of CFC1 is identical. USP made the election described in . As a result of the election, USP was required to increase its basis in the stock of CFC1 by $90x under , and to decrease its basis in the stock of CFC1 by $90x under . Pursuant to , USP netted the increase of $90x against the decrease of $90x and made no net adjustment to the basis in the stock of CFC1. For purposes of determining the value of the stock of CFC1 at the beginning of the 2019 taxable year, without regard to amounts included in basis under section or , USP's adjusted basis in the stock of CFC1 is $600x (before the application of of this section).
(ii) Analysis Under of this section, USP's adjusted basis in the stock of CFC1 is determined as if USP did not make the election described in . While USP made the election, no adjustment was made to the stock of CFC1 as a result of the election. However, USP's adjusted basis in the stock of CFC1 is then reduced by $90x, the amount described in , without regard to the rules regarding the netting of basis described in . No adjustment is made to USP's basis in the stock of CFC1 for the amount described in . Accordingly, for purposes of determining the value of stock of CFC1 at the beginning of the 2019 taxable year, USP's adjusted basis in the stock of CFC1 is $510x ($600x−$90x).
(3) Example 3: Adjusted basis below zero
(i) Facts The facts are the same as in of this section (the facts in Example 1), except that for purposes of determining the value of the stock of CFC2 at the beginning of the 2019 taxable year, without regard to amounts included in basis under section or , USP's adjusted basis in the stock of CFC2 is $0 (before the application of of this section). Additionally, the adjusted basis of USP in the stock of CFC1 and CFC2 at the end of the 2019 taxable year is the same as at the beginning of that year, and as of the end of the 2019 taxable year, CFC1 has earnings and profits of $25x and CFC2 has earnings and profits of $50x that are attributable to the stock owned by USP and accumulated during the period that USP held the stock of CFC1 and CFC2.
(ii) Analysis The analysis is the same as in of this section (the analysis in Example 1) except that for purposes of determining the value of stock of CFC1 and CFC2 at the beginning of the 2019 taxable year, USP's adjusted basis in the stock of CFC2 is −$75x ($0−$75x). Because USP's basis in the stock of CFC1 and CFC2 is the same at the end of the 2019 taxable year, prior to the application of the adjustments in and of this section, USP's adjusted basis in the stock of CFC1 is $100x and USP's adjusted basis in the stock of CFC2 is −$75x. Under of this section, for purposes of apportioning expenses on the basis of the tax book value of assets, USP's adjusted basis in the stock of CFC1 is $125x ($100x + $25x). Under of this section, for purposes of apportioning expenses on the basis of the tax book value of assets, USP's adjusted basis in the stock of CFC2 is $0 because after applying of this section, USP's adjusted basis in the stock of CFC2 is less than zero (−$75x + $50x).
(4) Example 4: Election described in § 1.965-2(f)(2)(i) and adjusted basis below zero —(i) Facts. The facts are the same as in of this section (the facts in Example 3), except that USP made the election described in and, as result, recognized $75x of gain under .
(ii) Analysis The analysis is the same as in of this section (the analysis in Example 3).
(2) (ii)-(vi) [Reserved]. For further guidance, see through .
(3) Characterization of stock of controlled foreign corporations
(i) Operative sections
(A) Operative sections other than section 904 For purposes of applying this section to an operative section other than section , stock in a controlled foreign corporation (as defined in section ) is characterized as an asset in the relevant groupings on the basis of the asset method described in of this section, or the modified gross income method described in of this section. Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of assets is characterized in the hands of its United States shareholders under the asset method described in of this section. Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of modified gross income is characterized in the hands of its United States shareholders under the modified gross income method described in of this section.
(B) Section 904 as operative section For purposes of applying this section to section as the operative section, applies to characterize the stock of a controlled foreign corporation as an asset producing foreign source income in the separate categories described in , or as an asset producing U.S. source income in the residual grouping, in the hands of the United States shareholder, and to determine the portion of the stock that gives rise to an inclusion under section that is treated as an exempt asset under . also provides rules for subdividing the stock in the various separate categories and the residual grouping into a section subgroup and a non-section subgroup in order to determine the amount of the adjustments required by section and with respect to the section subgroup, and provides rules for determining the portion of the stock that gives rise to a dividend eligible for a deduction under section that is treated as an exempt asset under .
(ii) Asset method For further guidance, see .
(iii) Modified gross income method Under the modified gross income method, the taxpayer characterizes the tax book value of the stock of the first-tier controlled foreign corporation based on the gross income, net of interest expense, of the controlled foreign corporation (as computed under to include certain gross income, net of interest expense, of lower-tier controlled foreign corporations) within each relevant category for the taxable year of the controlled foreign corporation ending with or within the taxable year of the taxpayer. For purposes of this , however, the gross income, net of interest expense, of the first-tier controlled foreign corporation includes the total amount of gross subpart F income, net of interest expense, of any lower-tier controlled foreign corporation that was excluded under the rules of .
(4) Characterization of stock of noncontrolled 10-percent owned foreign corporations
(i) In general Except in the case of a nonqualifying shareholder described in of this section, the principles of , including the relevant rules of when section is the operative section, apply to characterize stock in a noncontrolled 10-percent owned foreign corporation (as defined in section ). Accordingly, stock in a noncontrolled 10-percent owned foreign corporation is characterized as an asset in the various separate categories on the basis of either the asset method described in or the modified gross income method described in . Stock in a noncontrolled 10-percent owned foreign corporation the interest expense of which is apportioned on the basis of assets is characterized in the hands of its shareholders under the asset method described in . Stock in a noncontrolled 10-percent owned foreign corporation the interest expense of which is apportioned on the basis of gross income is characterized in the hands of its shareholders under the modified gross income method described in .
(ii) Nonqualifying shareholders Stock in a noncontrolled 10-percent owned foreign corporation is characterized as a passive category asset in the hands of a shareholder that either is not a domestic corporation or is not a United States shareholder with respect to the noncontrolled 10-percent owned foreign corporation for the taxable year. Stock in a noncontrolled 10-percent owned foreign corporation is characterized as in the separate category described in section in the hands of any shareholder with respect to whom look-through treatment is not substantiated. See also . In the case of a noncontrolled 10-percent owned foreign corporation that is a passive foreign investment company with respect to a shareholder, stock in the noncontrolled 10-percent owned foreign corporation is characterized as a passive category asset in the hands of the shareholder if such shareholder does not meet the ownership requirements described in section .
(d) Treatment of notes
(1) General rule For further guidance, see .
(2) Characterization of related controlled foreign corporation notes The debt of a controlled foreign corporation is characterized in the same manner as the interest income derived from that debt obligation. See and for rules treating interest income as income in a separate category.
(e) Portfolio securities that constitute inventory or generate primarily gains For further guidance, see .
(f) Assets connected with capitalized, deferred, or disallowed interest
(1) In general In the case of any asset in connection with which interest expense accruing during a taxable year is capitalized, deferred, or disallowed under any provision of the Code, the value of the asset for allocation and apportionment purposes is reduced by the principal amount of indebtedness the interest on which is so capitalized, deferred, or disallowed. Assets are connected with debt (the interest on which is capitalized, deferred, or disallowed) only if using the debt proceeds to acquire or produce the asset causes the interest to be capitalized, deferred, or disallowed.
(2) Examples The following examples illustrate the application of of this section.
(i) Example 1: Capitalized interest under section 263A
(A) Facts X is a domestic corporation that uses the tax book value method of apportionment. X has $1,000x of indebtedness and incurs $100x of interest expense. Using $800x of the $1,000x debt proceeds to produce tangible property, X capitalizes $80x of interest expense under the rules of section . X deducts the remaining $20x of interest expense.
(B) Analysis Because interest on $800x of debt is capitalized under section by reason of the use of debt proceeds to produce the tangible property, $800x of the principal amount of X's debt is connected to the tangible property under of this section. Therefore, for purposes of apportioning the remaining $20x of X's interest expense, the adjusted basis of the tangible property is reduced by $800x.
(ii) Example 2: Disallowed interest under section 163(l)
(A) Facts X, a domestic corporation, owns 100% of the stock of Y, a domestic corporation. X and Y file a consolidated return and use the tax book value method of apportionment. In Year 1, X makes a loan of $1,000x to Y (Loan A) and Y then uses the Loan A proceeds to acquire in a cash purchase all the stock of a foreign corporation, Z. Interest on Loan A is payable in U.S. dollars or, at the option of Y, in stock of Z.
(B) Analysis Under section , Loan A is a disqualified debt instrument because interest on Loan A is payable at the option of Y in stock of a related party to Y. Because Loan A is a disqualified debt instrument, section disallows Y's interest deduction for interest payable on Loan A. However, the value of the Z stock is not reduced under of this section because the use of the Loan A proceeds to acquire the stock of Z is not the cause of Y's interest deduction being disallowed. Rather, the Loan A terms allowing interest to be paid in stock of Z is the cause of Y's interest deduction being disallowed under section . Therefore, no adjustment is made to Y's adjusted basis in the stock of Z for purposes of allocating the interest expense of X and Y.
(g) Special rules for FSCs For further guidance, see through .
(h)-(j) [Reserved]
(k) Applicability date
(1) Except as provided in of this section, this section applies to taxable years that both begin after December 31, 2017, and end on or after December 4, 2018.
(2) of this section applies to taxable years that end on or after December 16, 2019. For taxable years that both begin after December 31, 2017, and end on or after December 4, 2018, and before December 16, 2019, see as contained in 26 CFR part 1 revised as of April 1, 2019.
[T.D. 9452, 74 FR 27874, June 11, 2009, as amended by T.D. 9866, 84 FR 29335, June 21, 2019; T.D. 9882, 84 FR 69069, Dec. 17, 2019; T.D. 9922, 85 FR 72040, Nov. 12, 2020]