D, a domestic corporation, owns 80 percent of the outstanding stock of M, a foreign manufacturing corporation. For an uninterrupted 36-month period ending December 31, 1970, M was engaged in a trade or business in the United States (through a U.S. branch), and effectively connected gross income from that business equaled 60 percent of M’s gross income from all sources for the period. M’s only distribution for 1971 is a $100,000 cash dividend to D.
Because M derived 50 percent or more of its gross income from a U.S. trade or business during the testing period, a portion of the dividend is treated as U.S.-source income. Applying the 60 percent effectively-connected ratio, $60,000 ($100,000 × 60%) is U.S.-source under § 1.861-3, and the remaining $40,000 ($100,000 − $60,000) is treated under § 1.862-1(a)(2) as foreign-source income.
Under old section 245(a), D is entitled to a dividends-received deduction of $51,000 ($60,000 × 85%), computed on the U.S.-source portion only. The percentage shown reflects the law in effect for the example year; see section 243(a) for current DRD percentages. Under subdivision (ii), $40,000 ($100,000 − [$51,000 × 100/85]) is treated as foreign-source income for purposes of the section 904(a) foreign tax credit limitation.
Because 50% or more of M’s gross income was effectively connected with a U.S. trade or business over the 36-month test period, a proportionate slice of the dividend M pays is re-sourced as U.S.-source income.
Using M’s 60% effectively-connected ratio, $60,000 of the $100,000 dividend is U.S.-source under § 1.861-3 and $40,000 is foreign-source under § 1.862-1(a)(2).
Under section 245(a), D’s dividends-received deduction is $51,000 — 85% of the $60,000 U.S.-source portion, not of the full $100,000.
Subdivision (ii) reclassifies $40,000 as foreign-source income for the section 904(a) foreign tax credit limitation, so the sourcing rule cuts both ways.
