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Under the Senate amendment, qualifying director shares is not treated as a second class of stock. Instead, payments on the stock are deductible by the corporation and includible in income of the holder of the stock. No allocations of income or loss are made with respect to the stock. Qualifying

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   Effective date.--The provision applies to taxable years beginning after December 31, 1999.

   The conference agreement follows the Senate amendment.

   In general

   In order to compute the foreign tax credit limitation, a taxpayer must determine the amount of taxable income from foreign sources. Thus, the taxpayer must allocate and apportion deductions between items of U.S.-source gross income, on the one hand, and items of foreign- source gross income, on the other. Generally, it is left to the Treasury to provide detailed rules for the allocation an d apportionment of expenses.

   In the case of interest ex pense, r egulations generally are based on the approach that money is fungible and that interest ex pense is properly attributable to all business activities and property of a taxpayer, regardless of any specific purpose for incurring an obligation on which interest is paid. (Exceptions to the fungibility concept are recognized or required, however, in particular cases, some of which are described below.) The Code provides that for interest al location pu rposes all members of an affiliated group of corporations generally are to be treated as a single corporation (the so-called ``one-taxpayer rule''), and that allocation mu st be made on the basis of assets rather than gross income.

   Affiliated group

   In general

   The term ``affiliated group'' in this context generally is defined by reference to the rules for determining whether corporations are eligible to file consolidated returns. However, some groups of corporations are eligible to file consolidated returns yet are not treated as affiliated for interest al location pu rposes, and other groups of corporations are treated as affiliated for interest al location pu rposes even though they are not eligible to file consolidated returns. Thus, under the one-taxpayer rule, the factors affecting the allocation of interest ex pense of one corporation may affect the sourcing of taxable income of another, related corporation even if the two corporations do not elect to file, or are ineligible to file, consolidated returns. (See, e.g., Treas. Reg. sec. 1.861-11T(g).)

   Definition of affiliated group--consolidated return rules

   For consolidation purposes, the term ``affiliated group'' means one or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation, but only if the common parent owns directly at least 80 percent of the total voting power of all classes of stock and at least 80 percent of the total value of all outstanding stock of at least one other includible corporation. In addition, for each such other includible corporation (except the common parent), stock possessing at least 80 percent of the total voting power of all classes of its stock and at least 80 percent of the total value of all of its outstanding stock must be directly owned by one or more other includible corporations.

   Generally the term ``includible corporation'' means any domestic corporation except certain corporations exempt from tax under section 501 (for example, corporations organized and operated exclusively for charitable or educational purposes), certain life insurance companies, corporations electing application of the possession tax credit, regulated investment companies, real estate investment trusts, and domestic international sales corporations. A foreign corporation generally is not an includible corporation.

   Definition of affiliated group--special interest al location ru les

   Subject to exceptions, the consolidated return and interest al location de finitions of affiliation generally are consistent with each other.\64\ For example, both definitions exclude all foreign corporations from the affiliated group. Thus, while debt generally is considered fungible among the assets of a group of domestic affiliated corporations, the same rule does not apply as between the domestic and foreign members of a group with the same degree of common control as the domestic affiliated group. \64\ One such exception is that the affiliated group for interest al location pu rposes includes section 936 corporations that are excluded from the consolidated group.

   Banks, savings institutions and other financial affiliates

   The affiliated group for interest al location pu rposes generally excludes what are referred to in the regulations as ``financial corporations'' (Treas. Reg. sec. 1.861-11T(d)(4)). These include any corporation, otherwise a member of the affiliated group for consolidation purposes, that is a financial institution (described in section 581 or section 591), the business of which is predominantly with persons other than related persons or their customers, and which is required by State or Federal law to be operated separately from any other entity which is not a financial institution (sec. 864(e)(5)(C)). The category of financial corporations also includes, to the extent provided in regulations, bank holding companies, subsidiaries of banks and bank holding companies, and savings institutions predominantly engaged in the active conduct of a banking, financing, or similar business (sec. 864(e)(5)(D)).

   A financial corporation is not treated as a member of the regular affiliated group for purposes of applying the one-taxpayer rule to other nonfinancial members of that group. Instead, all such financial corporations that would be so affiliated are treated as a separate single corporation for interest al location pu rposes.

   Worldwide affiliated group election

   The House bill modifies the present-law interest ex pense al location ru les (which generally apply for purposes of computing the foreign tax credit limitations) by providing a one- time election under which the taxable income of the domestic members of an affiliated group from sources outside the United States generally would be determined by allocating and apportioning interest ex pense of the domestic members of a worldwide affiliated group on a worldwide-group basis. The election provides taxpayers with the option either to apply fungibility principles on a worldwide basis or to continue to apply present law.

   Under the House bill, the common parent of an affiliated group can make a one-time election to apply the present-law interest ex pense al location an d apportionment rules under section 864(e) by allocating and apportioning interest ex pense of the domestic members of the worldwide affiliated group on a worldwide-group basis. If an affiliated group makes this election, subject to certain modifications and exceptions discussed below, the taxable income of the domestic members of the worldwide affiliated group from sources outside the United States is determined by allocating and apportioning the interest ex pense of those domestic members to foreign-source income in an amount equal to the worldwide affiliated group's worldwide interest ex pense mu ltiplied by a ratio of the foreign assets of the worldwide affiliated group over the total assets of the worldwide affiliated group.

   For purposes of the new elective rules based on worldwide fungibility, the worldwide affiliated group means all corporations in an affiliated group (as that term is defined under present law for interest ex pense al location pu rposes) \65\ as well as any foreign corporations with respect to which domestic members of the affiliated group own stock meeting the ownership requirements for treatment as a controlled foreign corporation under section 957(a) (without regard to the constructive ownership rules of section 958(b)). Hence, if more than 50 percent of the total combined voting power or the total value of the stock of a foreign corporation is owned (directly or indirectly) by domestic members of the affiliated group that are U.S. shareholders (i.e., that own 10 percent or more of the total combined voting power of the stock of such foreign corporation), then such foreign corporation is included in an electing worldwide affiliated group. \65\ The bill expands the present-law definition of an affiliated group for interest ex pense al location pu rposes to include certain insurance companies that are generally excluded from an affiliated group under section 1504(b)(2) (without regard to whether such companies are covered by an election under section 1504(c)(2)). As is the case under present law, the affiliated group includes section 936 corporations.

   With respect to foreign corporations included in a worldwide affiliated group, the House bill provides that only a pro rata portion of such foreign corporation's interest ex pense an d assets is treated as attributable to the worldwide affiliated group and taken into account for purposes of determining the allocation an d apportionment of interest ex pense. T he pro rata portion is determined by the ratio of the value of the stock of the foreign corporation owned by domestic members of the worldwide affiliated group (regardless of whether the foreign corporation qualifies as more than 50-percent owned because of either vote or value) to the total value of the stock of such foreign corporation.

   In short, the taxable income from sources outside the United States of electing domestic group members generally is determined by allocating and apportioning interest ex pense of the domestic members of the worldwide affiliated group as if all of the interest ex pense an d assets of 80-percent or greater owned domestic corporations (i.e., corporations that are part of the affiliated group under present-law section 864(e)(5)(A) as modified to include insurance companies) and a pro rata portion of the interest ex pense an d assets of greater than 50-percent owned foreign subsidiaries were attributable to a single corporation.

   Although a pro rata portion of the interest ex pense of a foreign subsidiary is taken into account for purposes of allocating the interest ex pense of the domestic members of the electing worldwide affiliated group for foreign tax credit limitation purposes, the interest ex pense in curred by a foreign subsidiary is not deductible on a U.S. return.

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   The worldwide affiliated group election is to be made by the common parent of the affiliated group. It must be made for the first taxable year beginning after December 31, 2001 (the effective date under the House bill), in which a worldwide affiliated group exists that includes at least one foreign corporation that meets the requirements for inclusion in a worldwide affiliated group. Once made, the election applies to the common parent and all other members of the worldwide affiliated group for the taxable year for which the election was made and all subsequent taxable years.

   Annual elections

   Regardless of whether a taxpayer elects to continue to be governed by the present-law allocation ru les or to apply the new worldwide fungibility principle, the House bill provides two annual elections that are exceptions to the ``one-taxpayer'' rule described above: (1) the ``subsidiary group'' election, and (2) a ``financial institution group'' election.

   Subsidiary group election

   Under the subsidiary group election, at the annual election of the common parent of the affiliated group, certain interest ex pense at tributable to qualified indebtedness incurred by a domestic member of the affiliated group (other than the common parent) is allocated and apportioned by treating the borrower and its direct and indirect subsidiaries as a separate group (in which the borrower would be treated as the common parent). The regime that is elected by the entire affiliated group (i.e., present law or the worldwide fungibility principles of the House bill) applies to all the qualified indebtedness of the members of that separate electing subsidiary group. For this purpose, qualified indebtedness generally means any borrowing from unrelated parties that is not guaranteed or in any other way supported by any corporation within the same affiliated group (other than a member of the subsidiary group) of the borrower.

   If the common parent of the affiliated group makes the election with respect to a domestic member of an affiliated group, the subsidiary group election applies to all direct and indirect subsidiaries of that member. No member of an electing subsidiary group can be treated as a member of another electing subsidiary group. Therefore, a separate subsidiary group election could not be made with respect to lower-tier subsidiaries in an electing subsidiary group. If the subsidiary group election is made, the House bill also provides that an ``equalization'' rule applies under which interest ex pense (i f any) incurred by domestic members of the affiliated group with respect to indebtedness that is not qualified indebtedness of an electing subsidiary group is allocated first to foreign-source income to the extent necessary to achieve (if possible) the allocation an d apportionment of interest ex pense to foreign-source income that would have resulted had the subsidiary group election not been made. In addition, the House bill provides anti-abuse rules under which certain transfers from one member of a subsidiary group to a member of the affiliated group outside of the subsidiary group are treated as reducing the amount of qualified indebtedness.

   Financial institution group election

   The House bill provides a financial institution group election that expands and replaces the bank group rules of present law (sec. 864(e)(5)(B)-(D)). At the annual election of the common parent of the affiliated group, the interest ex pense al location an d apportionment rules that apply to the affiliated group as a whole (i.e., present law or the worldwide approach), can be applied separately to a subgroup of the affiliated group consisting of corporations that are predominantly engaged in a banking, insurance, financing, or similar business (as well as certain bank holding companies). For this purpose, a corporation is predominantly engaged in such a business if at least 80 percent of its gross income is ``financial services income'' as described in section 904(d)(2)(C)(ii) and the regulations thereunder.\66\ The financial institution group rules, if elected, apply to all members of the affiliated group that are considered to be predominantly engaged in the active conduct of a banking, insurance, financing, or similar business, or otherwise considered to be a bank holding company. In addition, if a financial institution group election has been made, a member of the affiliated group that is part of the financial institution group could not also be a member of a separate subsidiary group at the same time. Anti-abuse rules similar to those that apply in connection with the subsidiary group election also apply to the financial institution group. \66\ See Treas. Reg. sec. 1.904-4(e)(2).

   Regulatory authority

   The House bill grants the Treasury Secretary authority to prescribe rules to carry out the purposes of the provision, including rules (1) to address changes in members of an affiliated group (including acquisitions or other business combinations of affiliated groups in which one group has made an election to apply the worldwide approach and the other group applies present law); (2) to prevent assets and interest ex pense fr om being taken into account more than once; and (3) to provide for direct allocation of interest ex pense in circumstances where such allocation wo uld be appropriate to carry out the purposes of the provision.

   Effective date

   The provision in the House bill is effective for taxable years beginning after December 31, 2001.

   The Senate amendment generally follows the House bill, but makes the following modifications.

   Worldwide affiliated group election

   The Senate amendment follows the House bill in that the common parent of an affiliated group can make a one-time election to apply the present-law interest ex pense al location an d apportionment rules under section 864(e) by allocating and apportioning interest ex pense of the domestic members of the worldwide affiliated group on a worldwide-group basis. If an affiliated group makes this election, subject to certain modifications and exceptions, the taxable income of the domestic members of the worldwide affiliated group from sources outside the United States is determined by allocating and apportioning the interest ex pense of those domestic members to foreign-source income in an amount equal to the excess (if any) of (1) the worldwide affiliated group's worldwide interest ex pense mu ltiplied by the ratio which the foreign assets of the worldwide affiliated group bears to the total assets of the worldwide affiliated group, over (2) the interest ex pense in curred by a foreign member of the group to the extent that such interest wo uld be allocated to foreign sources if the provision's principles were applied separately to the foreign members of the group.\67\ While this approach is generally the same as that under the House bill, the Senate amendment modifies the House bill to provide the actual allocation an d apportionment formula in the statute. \67\ Although the interest ex pense of a foreign subsidiary is taken into account for purposes of allocating the interest ex pense of the domestic members of the electing worldwide affiliated group for foreign tax credit limitation purposes, the interest ex pense in curred by a foreign subsidiary is not deductible on a U.S. return.

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