26 C.F.R. 1.901-2
 

1.901-2 Income, war profits, or excess profits tax paid or accrued.

(a) Definition of income, war profits, or excess profits tax--(1) In general.  Section 901 allows a credit for the amount of income, war profits or excess profits tax (referred to as "income tax" for purposes of this section and 1.901-2A and 1.903-1) paid to any foreign country.  Whether a foreign levy is an income tax is determined independently for each separate foreign levy.  A foreign levy is an income tax if and only if--

(i) It is a tax;  and

(ii) The predominant character of that tax is that of an income tax in the U.S. sense.

Except to the extent otherwise provided in paragraphs (a)(3)(ii) and (c) of this section, a tax either is or is not an income tax, in its entirety, for all persons subject to the tax.  Paragraphs (a), (b) and (c) of this section define an income tax for purposes of section 901.  Paragraph (d) of this section contains rules describing what constitutes a separate foreign levy.  Paragraph (e) of this section contains rules for determining the amount of tax paid by a person.  Paragraph (f) of this section contains rules for determining by whom foreign tax is paid.  Paragraph (g) of this section contains definitions of the terms "paid by," "foreign country," and "foreign levy."  Paragraph (h) of this section states the effective date of this section.

(2) Tax--(i) In general.  A foreign levy is a tax if it requires a compulsory payment pursuant to the authority of a foreign country to levy taxes.  A penalty, fine, interest, or similar obligation is not a tax, nor is a customs duty a tax.  Whether a foreign levy requires a compulsory payment pursuant to a foreign country's authority to levy taxes is determined by principles of U.S law and not by principles of law of the foreign country.  Therefore, the assertion by a foreign country that a levy is pursuant to the foreign country's authority to levy taxes is not determinative that, under U.S. principles, it is pursuant thereto.  Notwithstanding any assertion of a foreign country to the contrary, a foreign levy is not pursuant to a foreign country's authority to levy taxes, and thus is not a tax, to the extent a person subject to the levy receives (or will receive), directly or indirectly, a specific economic benefit (as defined in paragraph (a)(2)(ii)(B) of this section) from the foreign country in exchange for payment pursuant to the levy.  Rather, to that extent, such levy requires a compulsory payment in exchange for such specific economic benefit.  If, applying U.S. principles, a foreign levy requires a compulsory payment pursuant to the authority of a foreign country to levy taxes and also requires a compulsory payment in exchange for a specific economic benefit, the levy is considered to have two distinct elements:  a tax and a requirement of compulsory payment in exchange for such specific economic benefit.  In such a situation, these two distinct elements of the foreign levy (and the amount paid pursuant to each such element) must be separated.  No credit is allowable for a payment pursuant to a foreign levy by a dual capacity taxpayer (as defined in paragraph (a)(2)(ii)(A) of this section) unless the person claiming such credit establishes the amount that is paid pursuant to the distinct element of the foreign levy that is a tax.  See paragraph (a)(2)(ii) of this section and 1.901-2A.

(ii) Dual capacity taxpayers--(A) In general.  For purposes of this section and 1.901-2A and 1.903-1, a person who is subject to a levy of a foreign state or of a possession of the United States or of a political subdivision of such a state or possession and who also, directly or indirectly (within the meaning of paragraph (a)(2)(ii)(E) of this section) receives (or will receive) a specific economic benefit from the state or possession or from a political subdivision of such state or possession or from an agency or instrumentality of any of the foregoing is referred to as a "dual capacity taxpayer."  Dual capacity taxpayers are subject to the special rules of 1.901-2A.

(B) Specific economic benefit.  For purposes of this section and 1.901-2A and 1.903-1, the term "specific economic benefit" means an economic benefit that is not made available on substantially the same terms to substantially all persons who are subject to the income tax that is generally imposed by the foreign country, or, if there is no such generally imposed income tax, an economic benefit that is not made available on substantially the same terms to the population of the country in general.  Thus, a concession to extract government-owned petroleum is a specific economic benefit, but the right to travel or to ship freight on a government-owned airline is not, because the latter, but not the former, is made generally available on substantially the same terms.  An economic benefit includes property;  a service;  a fee or other payment;  a right to use, acquire or extract resources, patents or other property that a foreign country owns or controls (within the meaning of paragraph (a)(2)(ii)(D) of this section);  or a reduction or discharge of a contractual obligation.  It does not include the right or privilege merely to engage in business generally or to engage in business in a particular form.

(C) Pension, unemployment, and disability fund payments.  A foreign levy imposed on individuals to finance retirement, old-age, death, survivor, unemployment, illness, or disability benefits, or for some substantially similar purpose, is not a requirement of compulsory payment in exchange for a specific economic benefit, as long as the amounts required to be paid by the individuals subject to the levy are not computed on a basis reflecting the respective ages, life expectancies or similar characteristics of such individuals.

(D) Control of property.  A foreign country controls property that it does not own if the country exhibits substantial indicia of ownership with respect to the property, for example, by both regulating the quantity of property that may be extracted and establishing the minimum price at which it may be disposed of.

(E) Indirect receipt of a benefit.  A person is considered to receive a specific economic benefit indirectly if another person receives a specific economic benefit and that other person--

(1) Owns or controls, directly or indirectly, the first person or is owned or controlled, directly or indirectly, by the first person or by the same persons that own or control, directly or indirectly, the first person;  or

(2) Engages in a transaction with the first person under terms and conditions such that the first person receives, directly or indirectly, all or part of the value of the specific economic benefit.

(3) Predominant character.  The predominant character of a foreign tax is that of an income tax in the U.S. sense--

(i) If, within the meaning of paragraph (b)(1) of this section, the foreign tax is likely to reach net gain in the normal circumstances in which it applies,

(ii) But only to the extent that liability for the tax is not dependent, within the meaning of paragraph (c) of this section, by its terms or otherwise, on the availability of a credit for the tax against income tax liability to another country.

(b) Net gain--(1) In general.  A foreign tax is likely to reach net gain in the normal circumstances in which it applies if and only if the tax, judged on the basis of its predominant character, satisfies each of the realization, gross receipts, and net income requirements set forth in paragraphs (b)(2), (b)(3) and (b)(4), respectively, of this section.

(2) Realization--(i) In general.  A foreign tax satisfies the realization requirement if, judged on the basis of its predominant character, it is imposed--

(A) Upon or subsequent to the occurrence of events ("realization events") that would result in the realization of income under the income tax provisions of the Internal Revenue Code;

(B) Upon the occurrence of an event prior to a realization event ("a prerealization event") provided the consequence of such event is the recapture (in whole or part) of a tax deduction, tax credit or other tax allowance previously accorded to the taxpayer;  or

(C) Upon the occurrence of a prerealization event, other than one described in paragraph (b)(2)(i)(B) of this section, but only if the foreign country does not, upon the occurrence of a later event (other than a distribution or a deemed distribution of the income), impose tax ("second tax") with respect to the income on which tax is imposed by reason of such prerealization event (or, if it does impose a second tax, a credit or other comparable relief is available against the liability of such a second tax for tax paid on the occurrence of the prerealization event) and--

(1) The imposition of the tax upon such prerealization event is based on the difference in the values of property at the beginning and end of a period;  or

(2) The prerealization event is the physical transfer, processing, or export of readily marketable property (as defined in paragraph (b)(2)(iii) of this section).

A foreign tax that, judged on the basis of its predominant character, is imposed upon the occurrence of events described in this paragraph (b)(2)(i) satisfies the realization requirement even if it is also imposed in some situations upon the occurrence of events not described in this paragraph (b)(2)(i).  For example, a foreign tax that, judged on the basis of its predominant character, is imposed upon the occurrence of events described in this paragraph (b)(2)(i) satisfies the realization requirement even though the base of that tax also includes imputed rental income from a personal residence used by the owner and receipt of stock dividends of a type described in section 305(a) of the Internal Revenue Code.  As provided in paragraph (a)(1) of this section, a tax either is or is not an income tax, in its entirety, for all persons subject to the tax;  therefore, a foreign tax described in the immediately preceding sentence satisfies the realization requirement even though some persons subject to the tax will on some occasions not be subject to the tax except with respect to such imputed rental income and such stock dividends.  However, a foreign tax based only or predominantly on such imputed rental income or only or predominantly on receipt of such stock dividends does not satisfy the realization requirement.

(ii) Certain deemed distributions.  A foreign tax that does not satisfy the realization requirement under paragraph (b)(2)(i) of this section is nevertheless considered to meet the realization requirement if it is imposed with respect to a deemed distribution (e.g., by a corporation to a shareholder) of amounts that meet the realization requirement in the hands of the person that, under foreign law, is deemed to distribute such amount, but only if the foreign country does not, upon the occurrence of a later event (e.g., an actual distribution), impose tax ("second tax") with respect to the income on which tax was imposed by reason of such deemed distribution (or, if it does impose a second tax, a credit or other comparable relief is available against the liability for such a second tax for tax paid with respect to the deemed distribution).

(iii) Readily marketable property.  Property is readily marketable if--

(A) It is stock in trade or other property of a kind that properly would be included in inventory if on hand at the close of the taxable year or if it is held primarily for sale to customers in the ordinary course of business, and

(B) It can be sold on the open market without further processing or it is exported from the foreign country.

(iv) Examples.  The provisions of paragraph (b)(2) of this section may be illustrated by the following examples:

Example 1.  Residents of country X are subject to a tax of 10 percent on the aggregate net appreciation in fair market value during the calendar year of all shares of stock held by them at the end of the year.  In addition, all such residents are subject to a country X tax that qualifies as an income tax within the meaning of paragraph (a)(1) of this section.  Included in the base of the income tax are gains and losses realized on the sale of stock, and the basis of stock for purposes of determining such gain or loss is its cost.  The operation of the stock appreciation tax and the income tax as applied to sales of stock is exemplified as follows:  A, a resident of country X, purchases stock in June, 1983 for 100u (units of country X currency) and sells it in May, 1985 for 160u.  On December 31, 1983, the stock is worth 120u and on December 31, 1984, it is worth 155u.  Pursuant to the stock appreciation tax, A pays 2u for 1983 (10 percent of (120u-100u)), 3.5u for 1984 (10 percent of (155u-120u)), and nothing in 1985 because no stock was held at the end of that year.  For purposes of the income tax, A must include 60u (160u-100u) in his income for 1985, the year of sale.  Pursuant to paragraph (b)(2)(i)(C) of this section, the stock appreciation tax does not satisfy the realization requirement because country X imposes a second tax upon the occurrence of a later event (i.e., the sale of stock) with respect to the income that was taxed by the stock appreciation tax and no credit or comparable relief is available against such second tax for the stock appreciation tax paid.

Example 2.  The facts are the same as in example (1) except that if stock was held on the December 31 last preceding the date of its sale, the basis of such stock for purposes of computing gain or loss under the income tax is the value of the stock on such December 31.  Thus, in 1985, A includes only 5u (160u- 155u) as income from the sale for purposes of the income tax.  Because the income tax imposed upon the occurrence of a later event (the sale) does not impose a tax with respect to the income that was taxed by the stock appreciation tax, the stock appreciation tax satisfies the realization requirement.  The result would be the same if, instead of a basis adjustment to reflect taxation pursuant to the stock appreciation tax, the country X income tax allowed a credit (or other comparable relief) to take account of the stock appreciation tax.  If a credit mechanism is used, see also paragraph (e)(4)(i) of this section.

Example 3.  Country X imposes a tax on the realized net income of corporations that do business in country X.  Country X also imposes a branch profits tax on corporations organized under the law of a country other than country X that do business in country X.  The branch profits tax is imposed when realized net income is remitted or deemed to be remitted by branches in country X to home offices outside of country X.  The branch profits tax is imposed subsequent to the occurrence of events that would result in realization of income (i.e., by corporations subject to such tax) under the income tax provisions of the Internal Revenue Code;  thus, in accordance with paragraph (b)(2)(i)(A) of this section, the branch profits tax satisfies the realization requirement.

Example 4.  Country X imposes a tax on the realized net income of corporations that do business in country X (the "country X corporate tax").  Country X also imposes a separate tax on shareholders of such corporations (the "country X shareholder tax").  The country X shareholder tax is imposed on the sum of the actual distributions received during the taxable year by such a shareholder from the corporation's realized net income for that year (i.e., income from past years is not taxed in a later year when it is actually distributed) plus the distributions deemed to be received by such a shareholder.  Deemed distributions are defined as (A) a shareholder's pro rata share of the corporation's realized net income for the taxable year, less (B) such shareholder's pro rata share of the corporation's country X corporate tax for that year, less (C) actual distributions made by such corporation to such shareholder from such net income.  A shareholder's receipt of actual distributions is a realization event within the meaning of paragraph (b)(2)(i)(A) of this section.  The deemed distributions are not realization events, but they are described in paragraph (b)(2)(ii) of this section. Accordingly, the country X shareholder tax satisfies the realization requirement.

(3) Gross receipts--(i) In general.  A foreign tax satisfies the gross receipts requirement if, judged on the basis of its predominant character, it is imposed on the basis of--

(A) Gross receipts;  or

(B) Gross receipts computed under a method that is likely to produce an amount that is not greater than fair market value.

A foreign tax that, judged on the basis of its predominant character, is imposed on the basis of amounts described in this paragraph (b)(3)(i) satisfies the gross receipts requirement even if it is also imposed on the basis of some amounts not described in this paragraph (b)(3)(i).

(ii) Examples.  The provisions of paragraph (b)(3)(i) of this section may be illustrated by the following examples:

Example 1.  Country X imposes a "headquarters company tax" on country X corporations that serve as regional headquarters for affiliated nonresident corporations, and this tax is a separate tax within the meaning of paragraph (d) of this section.  A headquarters company for purposes of this tax is a corporation that performs administrative, management or coordination functions solely for nonresident affiliated entities.  Due to the difficulty of determining on a case-by-case basis the arm's length gross receipts that headquarters companies would charge affiliates for such services, gross receipts of a headquarters company are deemed, for purposes of this tax, to equal 110 percent of the business expenses incurred by the headquarters company.  It is established that this formula is likely to produce an amount that is not greater than the fair market value of arm's length gross receipts from such transactions with affiliates.  Pursuant to paragraph (b)(3)(i)(B) of this section, the headquarters company tax satisfies the gross receipts requirement.

Example 2.  The facts are the same as in Example (1), with the added fact that in the case of a particular taxpayer, A, the formula actually produces an amount that is substantially greater than the fair market value of arm's length gross receipts from transactions with affiliates.  As provided in paragraph (a)(1) of this section, the headquarters company tax either is or is not an income tax, in its entirety, for all persons subject to the tax.  Accordingly, the result is the same as in example (1) for all persons subject to the headquarters company tax, including A.

Example 3.  Country X imposes a separate tax (within the meaning of paragraph  (d) of this section) on income from the extraction of petroleum.  Under that tax, gross receipts from extraction income are deemed to equal 105 percent of the fair market value of petroleum extracted.  This computation is designed to produce an amount that is greater than the fair market value of actual gross receipts;  therefore, the tax on extraction income is not likely to produce an amount that is not greater than fair market value.  Accordingly, the tax on extraction income does not satisfy the gross receipts requirement.  However, if the tax satisfies the criteria of 1.903-1(a), it is a tax in lieu of an income tax.

(4) Net income--(i) In general.  A foreign tax satisfies the net income requirement if, judged on the basis of its predominant character, the base of the tax is computed by reducing gross receipts (including gross receipts as computed under paragraph (b)(3)(i)(B) of this section) to permit--

(A) Recovery of the significant costs and expenses (including significant capital expenditures) attributable, under reasonable principles, to such gross receipts;  or

(B) Recovery of such significant costs and expenses computed under a method that is likely to produce an amount that approximates, or is greater than, recovery of such significant costs and expenses.

A foreign tax law permits recovery of significant costs and expenses even if such costs and expenses are recovered at a different time than they would be if the Internal Revenue Code applied, unless the time of recovery is such that under the circumstances there is effectively a denial of such recovery.  For example, unless the time of recovery is such that under the circumstances there is effectively a denial of such recovery, the net income requirement is satisfied where items deductible under the Internal Revenue Code are capitalized under the foreign tax system and recovered either on a recurring basis over time or upon the occurrence of some future event or where the recovery of items capitalized under the Internal Revenue Code occurs less rapidly under the foreign tax system.  A foreign tax law that does not permit recovery of one or more significant costs or expenses, but that provides allowances that effectively compensate for nonrecovery of such significant costs or expenses, is considered to permit recovery of such costs or expenses. Principles used in the foreign tax law to attribute costs and expenses to gross receipts may be reasonable even if they differ from principles that apply under the Internal Revenue Code (e.g., principles that apply under section 265, 465 or 861(b) of the Internal Revenue Code).  A foreign tax whose base, judged on the basis of its predominant character, is computed by reducing gross receipts by items described in paragraph (b)(4)(i)(A) or (B) of this section satisfied the net income requirement even if gross receipts are not reduced by some such items.  A foreign tax whose base is gross receipts or gross income does not satisfy the net income requirement except in the rare situation where that tax is almost certain to reach some net gain in the normal circumstances in which it applies because costs and expenses will almost never be so high as to offset gross receipts or gross income, respectively, and the rate of the tax is such that after the tax is paid persons subject to the tax are almost certain to have net gain.  Thus, a tax on the gross receipts or gross income of businesses can satisfy the net income requirement only if businesses subject to the tax are almost certain never to incur a loss (after payment of the tax). In determining whether a foreign tax satisfied the net income requirement, it is immaterial whether gross receipts are reduced, in the base of the tax, by another tax, provided that other tax satisfies the realization, gross receipts and net income requirements.

(ii) Consolidation of profits and losses.  In determining whether a foreign tax satisfies the net income requirement, one of the factors to be taken into account is whether, in computing the base of the tax, a loss incurred in one activity (e.g., a contract area in the case of oil and gas exploration) in a trade or business is allowed to offset profit earned by the same person in another activity (e.g., a separate contract area) in the same trade or business.  If such an offset is allowed, it is immaterial whether the offset may be made in the taxable period in which the loss is incurred or only in a different taxable period, unless the period is such that under the circumstances there is effectively a denial of the ability to offset the loss against profit.  In determining whether a foreign tax satisfies the net income requirement, it is immaterial that no such offset is allowed if a loss incurred in one such activity may be applied to offset profit earned in that activity in a different taxable period, unless the period is such that under the circumstances there is effectively a denial of the ability to offset such loss against profit.  In determining whether a foreign tax satisfies the net income requirement, it is immaterial whether a person's profits and losses from one trade or business (e.g., oil and gas extraction) are allowed to offset its profits and losses from another trade or business (e.g., oil and gas refining and processing), or whether a person's business profits and losses and its passive investment profits and losses are allowed to offset each other in computing the base of the foreign tax.  Moreover, it is immaterial whether foreign law permits or prohibits consolidation of profits and losses of related persons, unless foreign law requires separate entities to be used to carry on separate activities in the same trade or business.  If foreign law requires that separate entities carry on such separate activities, the determination whether the net income requirement is satisfied is made by applying the same considerations as if such separate activities were carried on by a single entity.

(iii) Carryovers.  In determining whether a foreign tax satisfies the net income requirement, it is immaterial, except as otherwise provided in paragraph (b)(4)(ii) of this section, whether losses incurred during one taxable period may be carried over to offset profits incurred in different taxable periods.

(iv) Examples.  The provisions of this paragraph (b)(4) may be illustrated by the following examples:

Example 1.  Country X imposes an income tax on corporations engaged in business in country X;  however, that income tax is not applicable to banks. Country X also imposes a tax (the "bank tax") of 1 percent on the gross amount of interest income derived by banks from branches in country X;  no deductions are allowed.  Banks doing business in country X incur very substantial costs and expenses (e.g., interest expense) attributable to their interest income.  The bank tax neither provides for recovery of significant costs and expenses nor provides any allowance that significantly compensates for the lack of such recovery.  Since such banks are not almost certain never to incur a loss on their interest income from branches in country X, the bank tax does not satisfy the net income requirement.  However, if the tax on corporations is generally imposed, the bank tax satisfies the criteria of 1.903-1(a) and therefore is a tax in lieu of an income tax.

Example 2.  Country X law imposes an income tax on persons engaged in business in country X.  The base of that tax is realized net income attributable under reasonable principles to such business.  Under the tax law of country X, a bank is not considered to be engaged in business in country X unless it has a branch in country X and interest income earned by a bank from a loan to a resident of country X is not considered attributable to business conducted by the bank in country X unless a branch of the bank in country X performs certain significant enumerated activities, such as negotiating the loan.  Country X also imposes a tax (the "bank tax") of 1 percent on the gross amount of interest income earned by banks from loans to residents of country X if such banks do not engage in business in country X or if such interest income is not considered attributable to business conducted in country X.  For the same reasons as are set forth in example (1), the bank tax does not satisfy the net income requirement.  However, if the tax on persons engaged in business in country X is generally imposed, the bank tax satisfies the criteria of 1.903-1(a) and therefore is a tax in lieu of an income tax.

Example 3.  A foreign tax is imposed at the rate of 40 percent on the amount of gross wages realized by an employee;  no deductions are allowed.  Thus, the tax law neither provides for recovery of costs and expenses nor provides any allowance that effectively compensates for the lack of such recovery.  Because costs and expenses of employees attributable to wage income are almost always insignificant compared to the gross wages realized, such costs and expenses will almost always not be so high as to offset the gross wages and the rate of the tax is such that, under the circumstances, after the tax is paid, employees subject to the tax are almost certain to have net gain.  Accordingly, the tax satisfies the net income requirement.

Example 4.  Country X imposes a tax at the rate of 48 percent of the "taxable income" of nonresidents of country X who furnish specified types of services to customers who are residents of country X.  "Taxable income" for purposes of the tax is defined as gross receipts received from residents of country X (regardless of whether the services to which the receipts relate are performed within or outside country X) less deductions that permit recovery of the significant costs and expenses (including significant capital expenditures) attributable under reasonable principles to such gross receipts.  The country X tax satisfies the net income requirement.

Example 5.  Each of country X and province Y (a political subdivision of country X) imposes a tax on corporations, called the "country X income tax" and the "province Y income tax," respectively.  Each tax has an identical base, which is computed by reducing a corporation's gross receipts by deductions that, based on the predominant character of the tax, permit recovery of the significant costs and expenses (including significant capital expenditures) attributable under reasonable principles to such gross receipts.  The country X income tax does not allow a deduction for the province Y income tax for which a taxpayer is liable, nor does the province Y income tax allow a deduction for the country X income tax for which a taxpayer is liable.  As provided in paragraph (d)(1) of this section, each of the country X income tax and the province Y income tax is a separate levy.  Both of these levies satisfy the net income requirement;  the fact that neither levy's base allows a deduction for the other levy is immaterial in reaching that determination.

(c) Soak-up taxes--(1) In general.  Pursuant to paragraph (a)(3)(ii) of this section, the predominant character of a foreign tax that satisfies the requirement of paragraph (a)(3)(i) of this section is that of an income tax in the U.S. sense only to the extent that liability for the foreign tax is not dependent (by its terms or otherwise) on the availability of a credit for the tax against income tax liability to another country.  Liability for foreign tax is dependent on the availability of a credit for the foreign tax against income tax liability to another country only if and to the extent that the foreign tax would not be imposed on the taxpayer but for the availability of such a credit.  See also 1.903-1(b)(2).

(2) Examples.  The provisions of paragraph (c)(1) of this section may be illustrated by the following examples:

Example 1.  Country X imposes a tax on the receipt of royalties from sources in country X by nonresidents of country X.  The tax is 15 percent of the gross amount of such royalties unless the recipient is a resident of the United States or of country A, B, C, or D, in which case the tax is 20 percent of the gross amount of such royalties.  Like the United States, each of countries A, B, C, and D allows its residents a credit against the income tax otherwise payable to it for income taxes paid to other countries.  Because the 20 percent rate applies only to residents of countries which allow a credit for taxes paid to other countries and the 15 percent rate applies to residents of countries which do not allow such a credit, one-fourth of the country X tax would not be imposed on residents of the United States but for the availability of such a credit.  Accordingly, one-fourth of the country X tax imposed on residents of the United States who receive royalties from sources in country X is dependent on the availability of a credit for the country X tax against income tax liability to another country.

Example 2.  Country X imposes a tax on the realized net income derived by all nonresidents from carrying on a trade or business in country X.  Although country X law does not prohibit other nonresidents from carrying on business in country X, United States persons are the only nonresidents of country X that carry on business in country X in 1984.  The country X tax would be imposed in its entirety on a nonresident of country X irrespective of the availability of a credit for country X tax against income tax liability to another country. Accordingly, no portion of that tax is dependent on the availability of such a credit.

Example 3.  Country X imposes tax on the realized net income of all corporations incorporated in country X.  Country X allows a tax holiday to qualifying corporations incorporated in country X that are owned by nonresidents of country X, pursuant to which no country X tax is imposed on the net income of a qualifying corporation for the first ten years of its operations in country X.  A corporation qualifies for the tax holiday if it meets certain minimum investment criteria and if the development office of country X certifies that in its opinion the operations of the corporation will be consistent with specified development goals of country X.  The development office will not so certify to any corporation owned by persons resident in countries that allow a credit (such as that available under section 902 of the Internal Revenue Code) for country X tax paid by a corporation incorporated in country X.  In practice, tax holidays are granted to a large number of corporations, but country X tax is imposed on a significant number of other corporations incorporated in country X (e.g., those owned by country X persons and those which have had operations for more than 10 years) in addition to corporations denied a tax holiday because their shareholders qualify for a credit for the country X tax against income tax liability to another country. In the case of corporations denied a tax holiday because they have U.S. shareholders, no portion of the country X tax during the period of the denied 10-year tax holiday is dependent on the availability of a credit for the country X tax against income tax liability to another country.

Example 4.  The facts are the same as in example (3), except that corporations owned by persons resident in countries that will allow a credit for country X tax at the time when dividends are distributed by the corporations are granted a provisional tax holiday.  Under the provisional tax holiday, instead of relieving such a corporation from country X tax for 10 years, liability for such tax is deferred until the corporation distributes dividends.  The result is the same as in example (3).

(d) Separate levies--(1) In general.  For purposes of sections 901 and 903, whether a single levy or separate levies are imposed by a foreign country depends on U.S. principles and not on whether foreign law imposes the levy or levies in a single or separate statute.  A levy imposed by one taxing authority (e.g., the national government of a foreign country) is always separate for purposes of sections 901 and 903 from a levy imposed by another taxing authority (e.g., a political subdivision of that foreign country). Levies are not separate merely because different rates apply to different taxpayers.  For example, a foreign levy identical to the tax imposed on U.S. citizens and resident alien individuals by section 1 of the Internal Revenue Code is a single levy notwithstanding the levy has graduated rates and applies different rate schedules to unmarried individuals, married individuals who file separate returns and married individuals who file joint returns.  In general, levies are not separate merely because some provisions determining the base of the levy apply, by their terms or in practice, to some, but not all, persons subject to the levy.  For example, a foreign levy identical to the tax imposed by section 11 of the Internal Revenue Code is a single levy even though some provisions apply by their terms to some but not all corporations subject to the section 11 tax (e.g., section 465 is by its terms applicable to corporations described in sections 465(a)(1)(B) and 465(a)(1)(C), but not to other corporations), and even though some provisions apply in practice to some but not all corporations subject to the section 11 tax (e.g., section 611 does not, in practice, apply to any corporation that does not have a qualifying interest in the type of property described in section 611(a)). However, where the base of a levy is different in kind, and not merely in degree, for different classes of persons subject to the levy, the levy is considered for purposes of sections 901 and 903 to impose separate levies for such classes of persons.  For example, regardless of whether they are contained in a single or separate foreign statute, a foreign levy identical to the tax imposed by section 871(b) of the Internal Revenue Code is a separate levy from a foreign levy identical to the tax imposed by section 1 of the Internal Revenue Code as it applies to persons other than those described in section 871(b), and foreign levies identical to the taxes imposed by sections 11, 541, 881, 882, 1491 and 3111 of the Internal Revenue Code are each separate levies, because the base of each of those levies differs in kind, and not merely in degree, from the base of each of the others.  Accordingly, each such levy must be analyzed separately to determine whether it is an income tax within the meaning of paragraph (a)(1) of this section and whether it is a tax in lieu of an income tax within the meaning of paragraph (a) of 1.903-1.  Where foreign law imposes a levy that is the sum of two or more separately computed amounts, and each such amount is computed by reference to a separate base, separate levies are considered, for purposes of sections 901 and 903, to be imposed.  A separate base may consist, for example, of a particular type of income or of an amount unrelated to income, e.g., wages paid.  Amounts are not separately computed if they are computed separately merely for purposes of a preliminary computation and are then combined as a single base.  In the case of levies that apply to dual capacity taxpayers, see also 1.901-2A(a).

(2) Contractual modifications.  Notwithstanding paragraph (d)(1) of this section, if foreign law imposing a levy is modified for one or more persons subject to the levy by a contract entered into by such person or persons and the foreign country, then foreign law is considered for purposes of sections 901 and 903 to impose a separate levy for all persons to whom such contractual modification of the levy applies, as contrasted to the levy as applied to all persons to whom such contractual modification does not apply.  In applying the provisions of paragraph (c) of this section to a tax as modified by such a contract, the provisions of 1.903-1(b)(2) shall apply.

(3) Examples.  The provisions of paragraph (d)(1) of this section may be illustrated by the following examples:

Example 1.  A foreign statute imposes a levy on corporations equal to the sum of 15% of the corporation's realized net income plus 3% of its net worth.  As the levy is the sum of two separately computed amounts, each of which is computed by reference to a separate base, each of the portion of the levy based on income and the portion of the levy based on net worth is considered, for purposes of sections 901 and 903, to be a separate levy.

Example 2.  A foreign statute imposes a levy on nonresident alien individuals analogous to the taxes imposed by section 871 of the Internal Revenue Code. For the same reasons as set forth in example (1), each of the portion of the foreign levy analogous to the tax imposed by section 871(a) and the portion of the foreign levy analogous to the tax imposed by sections 871(b) and 1, is considered, for purposes of sections 901 and 903, to be a separate levy.

Example 3.  A single foreign statute or separate foreign statutes impose a foreign levy that is the sum of the products of specified rates applied to specified bases, as follows:

---------------------------------------------------- 

Base                  Rate (percent)

---------------------------------------------------- 

Net income from mining .................... 45 

Net income from manufacturing ............. 50 

Net income from technical services ........ 50 

Net income from other services ............ 45 

Net income from investments ............... 15 

All other net income ...................... 50 

---------------------------------------------------- 

In computing each such base, deductible expenditures are allocated to the type of income they generate.  If allocated deductible expenditures exceed the gross amount of a specified type of income, the excess may not be applied against income of a different specified type.  Accordingly, the levy is the sum of several separately computed amounts, each of which is computed by reference to a separate base.  Each of the levies on mining net income, manufacturing net income, technical services net income, other services net income, investment net income and other net income is, therefore, considered, for purposes of sections 901 and 903, to be a separate levy.

Example 4.  The facts are the same as in example (3), except that excess deductible expenditures allocated to one type of income are applied against other types of income to which the same rate applies.  The levies on mining net income and other services net income together are considered, for purposes of sections 901 and 903, to be a single levy since, despite a separate preliminary computation of the bases, by reason of the permitted application of excess allocated deductible expenditures, the bases are not separately computed.  For the same reason, the levies on manufacturing net income, technical services net income and other net income together are considered, for purposes of sections 901 and 903, to be a single levy.  The levy on investment net income is considered, for purposes of sections 901 and 903, to be a separate levy.  These results are not dependent on whether the application of excess allocated deductible expenditures to a different type of income, as described above, is permitted in the same taxable period in which the expenditures are taken into account for purposes of the preliminary computation, or only in a different (e.g., later) taxable period.

Example 5.  The facts are the same as in example (3), except that excess deductible expenditures allocated to any type of income other than investment income are applied against the other types of income (including investment income) according to a specified set of priorities of application.  Excess deductible expenditures allocated to investment income are not applied against any other type of income.  For the reason expressed in example (4), all of the levies are together considered, for purposes of sections 901 and 903, to be a single levy.

(e) Amount of income tax that is creditable--(1) In general.  Credit is allowed under section 901 for the amount of income tax (within the meaning of paragraph (a)(1) of this section) that is paid to a foreign country by the taxpayer.  The amount of income tax paid by the taxpayer is determined separately for each taxpayer.

(2) Refunds and credits--(i) In general.  An amount is not tax paid to a foreign country to the extent that it is reasonably certain that the amount will be refunded, credited, rebated, abated, or forgiven.  It is not reasonably certain that an amount will be refunded, credited, rebated, abated, or forgiven if the amount is not greater than a reasonable approximation of final tax liability to the foreign country.

(ii) Examples.  The provisions of paragraph (e)(2)(i) of this section may be illustrated by the following examples:

Example 1.  The internal law of country X imposes a 25 percent tax on the gross amount of interest from sources in country X that is received by a nonresident of country X.  Country X law imposes the tax on the nonresident recipient and requires any resident of country X that pays such interest to a nonresident to withhold and pay over to country X 25 percent of such interest, which is applied to offset the recipient's liability for the 25 percent tax.  A tax treaty between the United States and country X overrides internal law of country X and provides that country X may not tax interest received by a resident of the United States from a resident of country X at a rate in excess of 10 percent of the gross amount of such interest.  A resident of the United States may claim the benefit of the treaty only by applying for a refund of the excess withheld amount (15 percent of the gross amount of interest income) after the end of the taxable year.  A, a resident of the United States, receives a gross amount of 100u (units of country X currency) of interest income from a resident of country X, from sources in country X in the taxable year 1984, from which 25u of country X tax is withheld.  A files a timely claim for refund of the 15u excess withheld amount, 15u of the amount withheld (25u- 10u) is reasonably certain to be refunded;  therefore 15u is not considered an amount of tax paid to country X.

Example 2.  A's initial income tax liability under country X law is 100u  (units of country X currency).  However, under country X law A's initial income tax liability is reduced in order to compute its final tax liability by an investment credit of 15u and a credit for charitable contributions of 5u.  The amount of income tax paid by A is 80u.

Example 3.  A computes his income tax liability in country X for the taxable year 1984 as 100u (units of country X currency), files a tax return on that basis, and pays 100u of tax.  The day after A files that return, A files a claim for refund of 90u.  The difference between the 100u of liability reflected in A's original return and the 10u of liability reflected in A's refund claim depends on whether a particular expenditure made by A is nondeductible or deductible, respectively.  Based on an analysis of the country X tax law, A's country X tax advisors have advised A that it is not clear whether or not that expenditure is deductible.  In view of the uncertainty as to the proper treatment of the item in question under country X tax law, no portion of the 100u paid by A is reasonably certain to be refunded.  If A receives a refund, A must treat the refund as required by section 905(c) of the Internal Revenue Code.

Example 4.  A levy of country X, which qualifies as an income tax within the meaning of paragraph (a)(1) of this section, provides that each person who makes payment to country X pursuant to the levy will receive a bond to be issued by country X with an amount payable at maturity equal to 10 percent of the amount paid pursuant to the levy.  A pays 38,000u (units of country X currency) to country X and is entitled to receive a bond with an amount payable at maturity of 3800u.  It is reasonably certain that a refund in the form of property (the bond) will be made.  The amount of that refund is equal to the fair market value of the bond.  Therefore, only the portion of the 38,000u payment in excess of the fair market value of the bond is an amount of tax paid.

(3) Subsidies--(i) General rule.  An amount of foreign income tax is not an amount of income tax paid or accrued by a taxpayer to a foreign country to the extent that--

(A) The amount is used, directly or indirectly, by the foreign country imposing the tax to provide a subsidy by any means (including, but not limited to, a rebate, a refund, a credit, a deduction, a payment, a discharge of an obligation, or any other method) to the taxpayer, to a related person (within the meaning of section 482), to any party to the transaction, or to any party to a related transaction;  and

(B) The subsidy is determined, directly or indirectly, by reference to the amount of the tax or by reference to the base used to compute the amount of the tax.

(ii) Subsidy.  The term "subsidy" includes any benefit conferred, directly or indirectly, by a foreign country to one of the parties enumerated in paragraph (e)(3)(i)(A) of this section.  Substance and not form shall govern in determining whether a subsidy exists.  The fact that the U.S. taxpayer may derive no demonstrable benefit from the subsidy is irrelevant in determining whether a subsidy exists.

(iii) Official exchange rate.  A subsidy described in paragraph (e)(3)(i)(B) of this section does not include the actual use of an official foreign government exchange rate converting foreign currency into dollars where a free exchange rate also exists if--

(A) The economic benefit represented by the use of the official exchange rate is not targeted to or tied to transactions that give rise to a claim for a foreign tax credit;

(B) The economic benefit of the official exchange rate applies to a broad range of international transactions, in all cases based on the total payment to be made without regard to whether the payment is a return of principal, gross income, or net income, and without regard to whether it is subject to tax;  and

(C) Any reduction in the overall cost of the transaction is merely coincidental to the broad structure and operation of the official exchange rate.

In regard to foreign taxes paid or accrued in taxable years beginning before January 1, 1987, to which the Mexican Exchange Control Decree, effective as of December 20, 1982, applies, see Rev. Rul. 84-143, 1984-2 C.B. 127.

(iv) Examples.  The provisions of this paragraph (e)(3) may be illustrated by the following examples:

Example 1.  (i) Country X imposes a 30 percent tax on nonresident lenders with respect to interest which the nonresident lenders receive from borrowers who are residents of Country X, and it is established that this tax is a tax in lieu of an income tax within the meaning of 1.903-1(a).  Country X provides the nonresident lenders with receipts upon their payment of the 30 percent tax.  Country X remits to resident borrowers an incentive payment for engaging in foreign loans, which payment is an amount equal to 20 percent of the interest paid to nonresident lenders.

(ii) Because the incentive payment is based on the interest paid, it is determined by reference to the base used to compute the tax that is imposed on the nonresident lender.  The incentive payment is considered a subsidy under this paragraph (e)(3) since it is provided to a party (the borrower) to the transaction and is based on the amount of tax that is imposed on the lender with respect to the transaction.  Therefore, two-thirds (20 percent/30 percent) of the amount withheld by the resident borrower from interest payments to the nonresidential lender is not an amount of income tax paid or accrued for purposes of section 901(b).

Example 2.  (i) A U.S. bank lends money to a development bank in Country X.  The development bank relends the money to companies resident in Country X.  A withholding tax is imposed by Country X on the U.S. bank with respect to the interest that the development bank pays to the U.S. bank, and appropriate receipts are provided.  On the date that the tax is withheld, fifty percent of the tax is credited by Country X to an account of the development bank. Country X requires the development bank to transfer the amount credited to the borrowing companies.

(ii) The amount successively credited to the account of the development bank and then to the account of the borrowing companies is determined by reference to the amount of the tax and the tax base.  Since the amount credited to the borrowing companies is a subsidy provided to a party (the borrowing companies) to a related transaction and is based on the amount of tax and the tax base, it is not an amount paid or accrued as an income tax for purposes of section 901(b).

Example 3.  (i) A U.S. bank lends dollars to a Country X borrower.  Country X imposes a withholding tax on the lender with respect to the interest.  The tax is to be paid in Country X currency, although the interest is payable in dollars.  Country X has a dual exchange rate system, comprised of a controlled official exchange rate and a free exchange rate.  Priority transactions such as exports of merchandise, imports of merchandise, and payments of principal and interest on foreign currency loans payable abroad to foreign lenders are governed by the official exchange rate which yields more dollars per unit of Country X currency than the free exchange rate.  The Country X borrower remits the net amount of dollar interest due to the U.S. bank (interest due less withholding tax), pays the tax withheld in Country X currency to the Country X government, and provides to the U.S. bank a receipt for payment of the Country X taxes.

(ii) The use of the official exchange rate by the U.S. bank to determine foreign taxes with respect to interest is not a subsidy described in paragraph (e)(3)(i)(B) of this section.  The official exchange rate is not targeted to or tied to transactions that give rise to a claim for a foreign tax credit.  The use of the official exchange rate applies to the interest paid and to the principal paid.  Any benefit derived by the U.S. bank through the use of the official exchange rate is merely coincidental to the broad structure and operation of the official exchange rate.

Example 4.  (i) B, a U.S. corporation, is engaged in the production of oil and gas in Country X pursuant to a production sharing agreement between B, Country X, and the state petroleum authority of Country X.  The agreement is approved and enacted into law by the Legislature of Country X.  Both B and the petroleum authority are subject to the Country X income tax.  Each entity files an annual income tax return and pays, to the tax authority of Country X, the amount of income tax due on its annual income.  B is a dual capacity taxpayer as defined in 1.901-2(a)(2)(ii)(A).  Country X has agreed to return to the petroleum authority one-half of the income taxes paid by B by allowing it a credit in calculating its own tax liability to Country X.

(ii) The petroleum authority is a party to a transaction with B and the amount returned by Country X to the petroleum authority is determined by reference to the amount of the tax imposed on B.  Therefore, the amount returned is a subsidy as described in this paragraph (e)(3) and one-half the tax imposed on B is not an amount of income tax paid or accrued.

Example 5.  Assume the same facts as in Example 4, except that the state petroleum authority of Country X does not receive amounts from Country X related to tax paid by B.  Instead, the authority of Country X receives a general appropriation from Country X which is not calculated with reference to the amount of tax paid by B.  The general appropriation is therefore not a subsidy described in this paragraph (e)(3).

(v) Effective Date.  This paragraph (e)(3) shall apply to foreign taxes paid or accrued in taxable years beginning after December 31, 1986.

(4) Multiple levies--(i) In general.  If, under foreign law, a taxpayer's tentative liability for one levy (the "first levy") is or can be reduced by the amount of the taxpayer's liability for a different levy (the "second levy"), then the amount considered paid by the taxpayer to the foreign country pursuant to the second levy is an amount equal to its entire liability for that levy, and the remainder of the amount paid is considered paid pursuant to the first levy.  This rule applies regardless of whether it is or is not likely that liability for one such levy will always exceed liability for the other such levy.  For an example of the application of this rule, see example (5) of 1.903-1(b)(3).  If, under foreign law, the amount of a taxpayer's liability is the greater or lesser of amounts computed pursuant to two levies, then the entire amount paid to the foreign country by the taxpayer is considered paid pursuant to the levy that imposes such greater or lesser amount, respectively, and no amount is considered paid pursuant to such other levy.

(ii) Integrated tax systems.  [Reserved]

(5) Noncompulsory amounts--(i) In general.  An amount paid is not a compulsory payment, and thus is not an amount of tax paid, to the extent that the amount paid exceeds the amount of liability under foreign law for tax.  An amount paid does not exceed the amount of such liability if the amount paid is determined by the taxpayer in a manner that is consistent with a reasonable interpretation and application of the substantive and procedural provisions of foreign law (including applicable tax treaties) in such a way as to reduce, over time, the taxpayer's reasonably expected liability under foreign law for tax, and if the taxpayer exhausts all effective and practical remedies, including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, the taxpayer's liability for foreign tax (including liability pursuant to a foreign tax audit adjustment). Where foreign tax law includes options or elections whereby a taxpayer's tax liability may be shifted, in whole or part, to a different year or years, the taxpayer's use or failure to use such options or elections does not result in a payment in excess of the taxpayer's liability for foreign tax.  An interpretation or application of foreign law is not reasonable if there is actual notice or constructive notice (e.g., a published court decision) to the taxpayer that the interpretation or application is likely to be erroneous.  In interpreting foreign tax law, a taxpayer may generally rely on advice obtained in good faith from competent foreign tax advisors to whom the taxpayer has disclosed the relevant facts.  A remedy is effective and practical only if the cost thereof (including the risk of offsetting additional tax liability) is reasonable in light of the amount at issue and the likelihood of success.  A settlement by a taxpayer of two or more issues will be evaluated on an overall basis, not on an issue-by-issue basis, in determining whether an amount is a compulsory amount. A taxpayer is not required to alter its form of doing business, its business conduct, or the form of any business transaction in order to reduce its liability under foreign law for tax.

(ii) Examples.  The provisions of paragraph (e)(5)(i) of this section may be illustrated by the following examples:

Example 1.  A, a corporation organized and doing business solely in the United States, owns all of the stock of B, a corporation organized in country X.  In 1984 A buys merchandise from unrelated persons for $1,000,000, shortly thereafter resells that merchandise to B for $600,000, and B later in 1984 resells the merchandise to unrelated persons for $1,200,000.  Under the country X income tax, which is an income tax within the meaning of paragraph (a)(1) of this section, all corporations organized in country X are subject to a tax equal to 3 percent of their net income.  In computing its 1984 country X income tax liability B reports $600,000 ($1,200,000-$600,000) of profit from the purchase and resale of the merchandise referred to above.  The country X income tax law requires that transactions between related persons be reported at arm's length prices, and a reasonable interpretation of this requirement, as it has been applied in country X, would consider B's arm's length purchase price of the merchandise purchased from A to be $1,050,000.  When it computes its country X tax liability B is aware that $600,000 is not an arm's length price (by country X standards).  B's knowing use of a non-arm's length price (by country X standards) of $600,000, instead of a price of $1,050,000 (an arm's length price under country X's law), is not consistent with a reasonable interpretation and application of the law of country X, determined in such a way as to reduce over time B's reasonably expected liability for country X income tax.  Accordingly, $13,500 (3 percent of $450,000 ($1,050,000- $600,000)), the amount of country X income tax paid by B to country X that is attributable to the purchase of the merchandise from B's parent at less than an arm's length price, is in excess of the amount of B's liability for country X tax, and thus is not an amount of tax.

Example 2.  A, a corporation organized and doing business solely in the United States, owns all of the stock of B, a corporation organized in country X. Country X has in force an income tax treaty with the United States.  The treaty provides that the profits of related persons shall be determined as if the persons were not related.  A and B deal extensively with each other.  A and B, with respect to a series of transactions involving both of them, treat A as having $300,000 of income and B as having $700,000 of income for purposes of A's United States income tax and B's country X income tax, respectively.  B has no actual or constructive notice that its treatment of these transactions under country X law is likely to be erroneous.  Subsequently, the Internal Revenue Service reallocates $200,000 of this income from B to A under the authority of section 482 and the treaty.  This reallocation constitutes actual notice to A and constructive notice to B that B's interpretation and application of country X's law and the tax treaty is likely to be erroneous.  B does not exhaust all effective and practical remedies to obtain a refund of the amount of country X income tax paid by B to country X that is attributable to the reallocated $200,000 of income.  This amount is in excess of the amount of B's liability for country X tax and thus is not an amount of tax.

Example 3.  The facts are the same as in example (2), except that B files a claim for refund (an administrative proceeding) of country X tax and A or B invokes the competent authority procedures of the treaty, the cost of which is reasonable in view of the amount at issue and the likelihood of success. Nevertheless, B does not obtain any refund of country X tax.  The cost of pursuing any judicial remedy in country X would be unreasonable in light of the amount at issue and the likelihood of B's success, and B does not pursue any such remedy.  The entire amount paid by B to country X is a compulsory payment and thus is an amount of tax paid by B.

Example 4.  The facts are the same as in example (2), except that, when the Internal Revenue Service makes the reallocation, the country X statute of limitations on refunds has expired;  and neither the internal law of the country X nor the treaty authorizes the country X tax authorities to pay a refund that is barred by the statute of limitations.  B does not file a claim for refund, and neither A nor B invokes the competent authority procedures of the treaty.  Because the country X tax authorities would be barred by the statute of limitations from paying a refund, B has no effective and practicable remedies.  The entire amount paid by B to country X is a compulsory payment and thus is an amount of tax paid by B.

Example 5.  A is a U.S. person doing business in the country X.  In computing its income tax liability to the country X, A is permitted, at its election, to recover the cost of machinery used in its business either by deducting that cost in the year of acquisition or by depreciating that cost on the straight line method over a period of 2, 4, 6 or 10 years.  A elects to depreciate machinery over 10 years.  This election merely shifts A's tax liability to different years (compared to the timing of A's tax liability under a different depreciation period);  it does not result in a payment in excess of the amount of A's liability for country X income tax in any year since the amount of country X tax paid by A is consistent with a reasonable interpretation of country X law in such a way as to reduce over time A's reasonably expected liability for country X tax.  Because the standard of paragraph (e)(5)(i) of this section refers to A's reasonably expected liability, not its actual liability, events actually occurring in subsequent years (e.g., whether A has sufficient profit in such years so that such depreciation deductions actually reduce A's country X tax liability or whether country X tax rates change) are immaterial.

Example 6.  The internal law of country X imposes a 25 percent tax on the gross amount of interest from sources in country X that is received by a nonresident of country X.  Country X law imposes the tax on the nonresident recipient and requires any resident of country X that pays such interest to a nonresident to withhold and pay over to country X 25 percent of such interest, which is applied to offset the recipient's liability for the 25 percent tax.  A tax treaty between the United States and country X overrides internal law of country X and provides that country X may not tax interest received by a resident of the United States from a resident of country X at a rate in excess of 10 percent of the gross amount of such interest.  A resident of the United States may claim the benefit of the treaty only by applying for a refund of the excess withheld amount (15 percent of the gross amount of interest income) after the end of the taxable year.  A, a resident of the United States, receives a gross amount of 100u (units of country X currency) of interest income from a resident of country X from sources in country X in the taxable year 1984, from which 25u of country X tax is withheld.  A does not file a timely claim for refund.  15u of the amount withheld (25u-10u) is not a compulsory payment and hence is not an amount of tax.

(f) Taxpayer--(1) In general.  The person by whom tax is considered paid for purposes of sections 901 and 903 is the person on whom foreign law imposes legal liability for such tax, even if another person (e.g., a withholding agent) remits such tax.  For purposes of this section, 1.901-2A and 1.903- 1, the person on whom foreign law imposes such liability is referred to as the "taxpayer."  A foreign tax of a type described in paragraph (a)(2)(ii)(C) of this section is considered to be imposed on the recipients of wages if such tax is deducted from such wages under provisions that are comparable to section 3102(a) and (b) of the Internal Revenue Code.

(2) Party undertaking tax obligation as part of transaction--(i) In general.  Tax is considered paid by the taxpayer even if another party to a direct or indirect transaction with the taxpayer agrees, as a part of the transaction, to assume the taxpayer's foreign tax liability.  The rules of the foregoing sentence apply notwithstanding anything to the contrary in paragraph (e)(3) of this section.  See 1.901-2A for additional rules regarding dual capacity taxpayers.

(ii) Examples.  The provisions of paragraphs (f)(1) and (f)(2)(i) of this section may be illustrated by the following examples:

Example 1.  Under a loan agreement between A, a resident of country X, and B, a United States person, A agrees to pay B a certain amount of interest net of any tax that country X may impose on B with respect to its interest income.  Country X imposes a 10 percent tax on the gross amount of interest income received by nonresidents of country X from sources in country X, and it is established that this tax is a tax in lieu of an income tax within the meaning of 1.903-1(a).  Under the law of country X this tax is imposed on the nonresident recipient, and any resident of country X that pays such interest to a nonresident is required to withhold and pay over to country X 10 percent of the amount of such interest, which is applied to offset the recipient's liability for the tax.  Because legal liability for the tax is imposed on the recipient of such interest income, B is the taxpayer with respect to the country X tax imposed on B's interest income from B's loan to A.  Accordingly, B's interest income for federal income tax purposes includes the amount of country X tax that is imposed on B with respect to such interest income and that is paid on B's behalf by A pursuant to the loan agreement, and, under paragraph (f)(2)(i) of this section, such tax is considered for purposes of section 903 to be paid by B.

Example 2.  The facts are the same as in example (1), except that in collecting and receiving the interest B is acting as a nominee for, or agent of, C, who is a United States person.  Because C (not B) is the beneficial owner of the interest, legal liability for the tax is imposed on C, not B (C's nominee or agent).  Thus, C is the taxpayer with respect to the country X tax imposed on C's interest income from C's loan to A.  Accordingly, C's interest income for federal income tax purposes includes the amount of country X tax that is imposed on C with respect to such interest income and that is paid on C's behalf by A pursuant to the loan agreement.  Under paragraph (f)(2)(i) of this section, such tax is considered for purposes of section 903 to be paid by C.  No such tax is considered paid by B.

Example 3.  Country X imposes a tax called the "country X income tax."  A, a United States person engaged in construction activities in country X, is subject to that tax.  Country X has contracted with A for A to construct a naval base.  A is a dual capacity taxpayer (as defined in paragraph (a)(2)(ii)(A) of this section) and, in accordance with paragraphs (a)(1) and (c)(1) of 1.901-2A, A has established that the country X income tax as applied to dual capacity persons and the country X income tax as applied to persons other than dual capacity persons together constitute a single levy.  A has also established that that levy is an income tax within the meaning of paragraph (a)(1) of this section.  Pursuant to the terms of the contract, country X has agreed to assume any country X tax liability that A may incur with respect to A's income from the contract.  For federal income tax purposes, A's income from the contract includes the amount of tax liability that is imposed by country X on A with respect to its income from the contract and that is assumed by country X;  and for purposes of section 901 the amount of such tax liability assumed by country X is considered to be paid by A.  By reason of paragraph (f)(2)(i) of this section, country X is not considered to provide a subsidy, within the meaning of paragraph (e)(3) of this section, to A.

(3) Taxes paid on combined income.  If foreign income tax is imposed on the combined income of two or more related persons (for example, a husband and wife or a corporation and one or more of its subsidiaries) and they are jointly and severally liable for the income tax under foreign law, foreign law is considered to impose legal liability on each such person for the amount of the foreign income tax that is attributable to its portion of the base of the tax, regardless of which person actually pays the tax.

(g) Definitions.  For purposes of this section and 1.901-2A and 1.903-1, the following definitions apply:

(1) The term "paid" means "paid or accrued";  the term "payment" means  "payment or accrual";  and the term "paid by" means "paid or accrued by or on behalf of."

(2) The term "foreign country" means any foreign state, any possession of the United States, and any political subdivision of any foreign state or of any possession of the United States.  The term "possession of the United States" includes Puerto Rico, the Virgin Islands, Guam, the Northern Mariana Islands and American Samoa.

(3) The term "foreign levy" means a levy imposed by a foreign country.

(h) Effective date--(1) In general.  This section, 1.901-2A, and 1.903-1 apply to taxable years beginning after November 14, 1983.  In addition, a person may elect to apply the provisions of this section, 1.901-2A, and 1.903-1 to earlier years.  See paragraph (h)(2) of this section.

(2) Election to apply regulations to earlier years--(i) Scope of election.  An election to apply the provisions of this section, 1.901-2A, and 1.903-1 to taxable years beginning on or before November 14, 1983, is made with respect to one or more foreign states and possessions of the United States with respect to a taxable year of the person making the election beginning on or before November 14, 1983.  Such election requires all of the provisions of this section, 1.901-2A, and 1.903-1 to be applied to such taxable year and to all subsequent taxable years of the person making the election ("elected years").  If an election applies to a foreign state or to a possession of the United States ("election country"), it applies to all taxes of the election country and to all taxes of all political subdivisions of the election country.  An election does not apply to foreign taxes carried forward to any elected year from any taxable year to which the election does not apply.  Such election does apply to foreign taxes carried back or forward from any elected year to any taxable year.

(ii) Effect of election.  An election to apply the regulations to earlier years has no effect on the limitations on assessment and collection or on the limitations on credit or refund (see Chapter 66 of the Internal Revenue Code).

(iii) Manner of making election.  An election to apply the regulations to one or more earlier taxable years is made by attaching a statement to a return, amended return, or claim for refund for the earliest taxable year to which the election relates.  Such statement shall state that the election is made and, unless the election is to apply to all foreign countries, the statement shall designate the election countries.  In the absence of such a designation of the election countries, all foreign countries shall be election countries.

(iv) Time for making election.  An election to apply the regulations to earlier taxable years must be made by October 12, 1984, except that if a person who has deducted (instead of credited) foreign taxes in its United States income tax return for such an earlier taxable year validly makes an election to credit (instead of deduct) such taxes in a timely filed amended return for such earlier taxable year and such amended return is filed after such date, an election to apply the regulations to such earlier taxable year must be made in such amended return.

(v) Revocation of election.  An election to apply the regulations to earlier taxable years may not be revoked.

(vi) Affiliated groups.  A member of an affiliated group that files a consolidated United States income tax return may apply the regulations to earlier years only if an election to so apply them has been made by the common parent of such affiliated group on behalf of all members of the group.

Approved by the Office of Management and Budget under control number 1545-0746.