Prior to TRA 86, the earnings and profits ("E&P") of a foreign corporation were computed and translated into dollars under the rules of either Sec. 902 or Sec. 964 depending on the reason that the translation was required. The Sec. 964 method ("the Subpart F method" or "the net worth method") was used for calculating the amount of deemed income inclusions under Secs. 951(a), 1248 and 367(b) and the associated deemed paid foreign tax credits under Sec. 960. Sec. 964 E&P consisted of the current year's operating income and foreign exchange gains and losses based on a translation of the foreign corporation's balance sheet.

The Sec. 902 method ("the profit and loss method") was used for computing the taxable portion of actual dividends (as opposed to deemed income inclusions) as well as the associated deemed paid foreign tax credits under Sec. 902. Sec. 902 E&P includes only operating income (e.g., translation gains and losses are excluded) and is translated into dollars only at the time of distribution rather than annually, as under Sec. 964.

TRA 86 eliminated the net worth method, thus establishing uniform translation rules for all applications. This change led to the need for guidance concerning the treatment of pre-1987 E&P computed under the nowobsolete Sec. 964 method. Notice 88-70, issued by the IRS on June 13, 1988 provides rules for the treatment of pre-1987 Sec. 964 E&P as well as rules for the carryforward and carryback of, respectively, both pre- 1987 and post-1986 E&P deficits for purposes of computing Sec. 960 deemed paid foreign tax credits.

In an important new rule, the notice resolves the issue of how to translate pre-1987 Sec. 964 E&P deficits by the simple expedient of translating them using the spot rate in effect on the first day of the first post-1986 taxable year ("the 1987 spot rate"). The notice also provides that the 1987 spot rate will be used for purposes of translating the amount of a controlled foreign corporation's (CFC) pre- 1987 investment in U.S. property under Sec. 956 (e.g., its "Sec. 956 investment"). The amount of pre-1987 Sec. 964 E&P is relevant to post-1986 taxable years because the amount of post-1986 income inclusions under Secs. 956, 1248 and 367(b) is generally limited to the amount of current plus accumulated E&P.

Due to the notice's methodology, a CFC's E&P for purposes of deemed income inclusions under Secs. 951(a), 1248 and 367(b) and the associated Sec. 960 foreign tax credits will consist of two pools, one being a pre-1987 pool calculated using the net worth method and a post- 1986 pool calculated using the profit and loss method. A more accurate method for measuring the value of the pre-1987 Sec. 964 E&P would have been to translate the E&P back into the CFC's functional currency using the original exchange rate and then reconvert them using the Sec. 902 method. Thus, while this method has the virtue of simplicity, it will yield some distortions to the extent that the result differs from the amount which would have resulted from a recalculation using the Sec. 902 method.

As stated above, the first major new rule contained in the notice provides for the translation of pre-1987 Sec. 964 E&P using the 1987 functional currency spot rate. The second major new rule concerns the use of pre-1987 E&P deficits for purposes of computing the denominator of a CFC's Sec. 960 deemed paid credit fraction based on a post-1986 income inclusion under Secs. 951(a), 1248 and 367(b). The notice provides that for purposes of computing the Sec. 960 denominator in such circumstances, the amount of any accumulated pre-1987 E&P deficit which can be brought forward, is the deficit calculated under Sec. 902.

The two rules described above can lead to inconsistent calculations. For example, a pre-1987 E&P deficit may be measured under Sec. 964 for purposes of computing the amount of a post-1986 deemed income inclusion (and, accordingly, the numerator of the Sec. 960 fraction) while the pre-1987 deficit, for purposes of computing the denominator, would be calculated under Sec. 902. Thus, the numerator and denominator of the Sec. 960 fraction will not be calculated consistently if a pre- 1987 deficit is carried forward to a post-1986 year in which there is a deemed income inclusion.

This deficit carryforward may increase or decrease the post-1986 Sec. 960 credit depending upon whether the carryforward partly reduces or entirely eliminates the denominator of the fraction. A partial reduction of the denominator would serve to increase the fraction and therefore the credit. Alternatively, elimination of the undistributed earnings pool which forms the denominator of the fraction would bar the availability of a credit for foreign taxes paid by the CFC, until additional earnings restored a positive balance in the pool.

Examples 1 and 2 of the Notice illustrate how such inconsistencies can arise. Example 2, for instance, involves a CFC with both pre-1987 Sec. 902 and Sec. 964 E&P deficits with the Sec. 964 deficit being the larger of the two. It then compares the results of a post-1986 actual dividend with a post-1986 Sec. 956 investment in U.S. property. The carryover of the Sec. 902 deficit reduces the post-1986 undistributed earnings pool, and thus the denominator of the foreign tax credit fraction, with respect to both the actual dividend and the Sec. 956 deemed income inclusion. Thus, the denominator in both foreign tax credit fractions is the same. The Sec. 902 deficit also reduces the post-1986 undistributed earnings pool for purposes of determining the taxable amount of the actual dividend under Sec. 316. The post-1986 undistributed earnings pool is similarly reduced by the Sec. 964 deficit for purposes of determining the income inclusion resulting from the Sec. 956 investment in U.S. property.

However, since the Sec. 964 deficit is greater, the numerator of the fraction is reduced below the amount of the numerator with respect to the fraction for the actual dividend. Since the denominator for both fractions is the same, the result where the Sec. 964 deficit is the greater of the two, as in the example, would be a reduced foreign tax credit. (In the example, the pre-1987 Sec. 964 deficit exceeds the amount of post-1986 undistributed earnings, thus reducing the numerator and, hence, the amount of the foreign tax credit itself to zero.) Thus, although the denominator in both foreign tax credit fractions is the same, the amount of the credit differs depending on whether there is an income inclusion in the form of an actual dividend or a deemed income inclusion under Secs. 951(a), 1248 or 367(b).

Example 3 illustrates a significant possible pitfall resulting from the interaction of the E&P deficit carryforward rules in the notice with the restrictive Sec. 952(c) rules concerning the carryforward of deficits for Subpart F purposes. Sec. 952(c) generally prohibits the carryforward of pre-1987 E&P deficits to reduce post-1986 Subpart F income inclusions. In contrast, the Notice provides that pre-1987 deficits carry forward to reduce the denominator of the Sec. 960 credit with respect to such inclusions. Where, for example, a deficit being carried forward reduced the denominator to zero, a taxpayer could have a Sec. 951 income inclusion without the benefit of a corresponding foreign tax credit.

The third section of the Notice concerns the carryback of E&P deficits from post-1986 years to pre-1987 years for purposes of computing Sec. 960 deemed paid credits. Notice 87-54 provided similar rules in the context of Sec. 902. These rules apply where there is a deemed income inclusion under Secs. 951(a), 1248 or 367(b) from a CFC in a post-1986 year in which the CFC has an accumulated Sec. 902 E&P deficit. The amount of the deficit to be carried back as well as its impact on the calculation of the Sec. 960 credit calculation is governed by this section. The amount of the deficit carryback reduces both pre- 1987 Sec. 902 and Sec. 964 E&P and is itself removed from the post- 1986 undistributed earnings pool. The mandatory deficit carryback reflects the IRS position embodied in Rev. Ruls. 74-550 and 87-72 that E&P deficits must be carried back for purposes of computing deemed paid credits.

Example 5, which involves a post-1986 deemed income inclusion with respect to a Sec. 956 investment in U.S. property, illustrates this rule. In the example, a post-1986 E&P deficit is carried back to a pre-1987 for purposes of computing the Sec. 960 credit. An alternate fact pattern in the example illustrates the rule, referred to earlier, that the amount of pre-1987 Sec. 956 investments in U.S. property is translated, for post-1986 years, using the 1987 spot rate. In the example, this has the beneficial effect of increasing the CFC's basis in the investment, thus reducing the exposure to future income inclusions under Sec. 956.

Notice 88-70 concerns the treatment of only overall limitation E&P. A companion document, Notice 88-71, deals with more complex situations involving the carryforward and carryback of a CFC's E&P in different categories.