A UNITED STATES DEPARTMENT OF COMMERCE PUBLICATION *<°'?% 1970 General Bulletin Interpretive Explanation and Analysis of the FOREIGN DIRECT INVESTMENT REGULATIONS U.S. DEPARTMENT OF COMMERCE Office of Foreign Direct Investments REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195 WEDNESDAY, OCTOBER 7, 1970 Rules and Regulations Title 15— COMMERCE AND FOREIGN TRADE Chapter X — Office of Foreign Direct Investments, Department of Com- merce [1970 General Bulletin] PART 1000— FOREIGN DIRECT INVESTMENT REGULATIONS Interpretative Analyses and State- ments With Respect to the Regula- tions Notice is hereby given that the Office of Foreign Direct Investments (OFDI) has issued the following 1970 General Bulletin (the 1970 Bulletin or the Bul- letin), interpreting and analyzing the Foreign Direct Investment Regulations (the regulations) applicable to the For- eign Direct Investment Program (the program) for calendar year 1970. The purpose of the Bulletin is to inter- pret, explain and amplify, by text and illustrative examples, principal provi- sions of the current regulations. State- ments in the Bulletin may have the effect of qualifying or modifying pro- visions of the regulations, the instruc- tions applicable to reporting forms or other official OFDI publications. Unless subsequently modified or rescinded by public notice, statements contained in this Bulletin shall represent the official position of OFDI. General Bulletin No. 1 and General Bulletin No. 2, dated October 10 and 25, 1968 (33 F.R. No. 198 (Part II) and No. 209 (Part III), respectively) were issued by OFDI as general interpretive guide-' lines for the regulations applicable to the program in effect during 1968. The 1969 General Bulletin, issued November 5, 1969 (34 F.R. 17806), interpreted the regulations as in effect during 1969. To the extent expressly or implicitly over- ruled or modified by the 1970 Bulletin, General Bulletin Nos. 1 and 2 and the 1969 General Bulletin are hereby super- seded insofar as concerns compliance with the regulations in effect for 1970, and extreme care should be exercised in basing substantive decisions upon the material in those Bulletins. In case of doubt concerning relevance of any such material, OFDI should be consulted. This 1970 General Bulletin is prin- cipally interpretive and, to the extent that any provision of the regulations or other official OFDI publications may be modified, the changes are generally in the nature of liberalization or relaxa- tion. Accordingly, it is not deemed nec- essary in the public interest to publish the Bulletin in proposed form for comment. Effective date. The 1970 General Bul- letin, as set forth below, shall be effec- tive on the date of publication in the Federal Register. (Sec. 5, Act of Oct. 6, 1917, 40 Stat. 415, as amended, 12 U.S.C. 95a; E.O. 11387,' Jan. 1, 1968, 33 P.R. 47) Richard P. Urfer, Director, Office of Foreign Direct Investments. September 17, 1970. Editorial Note: The Foreign Direct Invest- ment Regulations are published in Title 15, Chapter X, Part 1000 of the Code of Federal Regulations (CFR). All sections of the regu- lations contained in CFR are preceded by the designation "1000" (e.g., § 1000.201). The "1000" designation has, for convenience, been eliminated from section references contained in this 1970 General Bulletin. Sections of the Bulletin correspond to section numbers of the regulations, but are distinguished by use of the prefix "B" and a hyphenated numeral suffix indicating major topical divisions of the analytical discussion (e.g., §B201-1). The abbreviations "DI" and "AFN" are used to refer to "direct investor" and "affiliated foreign national," respectively. Table of Contents for 1970 General Bulletin Introduction General. Program changes in 1970. (i) Section 507 alternative minimum and Schedule A supplemental allowable, (ii) Section 506 incremental earnings allowable, (iii) Elimination of aggregate annual loss rule in § 503. (iv) Liberalization of Schedule C histori- cial allowable, (v) Conditions for making long-term foreign borrowing, (vi) General treatment for overseas finance subsidiaries. Summary of the Regulations, (i) Applicability. (ii) Requirements and restrictions, (iii) Calculation of direct investment, (iv) Authorized direct investment, (v) Long-term foreign borrowing, (vi) Foreign balance restrictions, (vii) Reporting requirements. Additional comments. B201 — Prohibited Direct Investment § B201-1 Introduction. § B201-2 General prohibition. § B201-3 Exclusions. (i) Financial institutions, (ii) Transfers of capital to foreign owners. 5 B201-4 Reduction of authorized direct investment or of period for measuring compliance. B203 — Liquid Foreign Balances § B203-1 Introduction. § B203-2 Summary. • § B203-3 Definition of foreign balances. § B203-4 Definition of liquid foreign balances. § B203-5 Foreign balances deemed held by aDI. § B203-6 Valuation of foreign balances. § B203-7 Limitation on amount of liquid foreign balances. § B203-8 Available proceeds of long-term foreign borrowing: Effect on positive net transfer of capital. (i) Available proceeds held in the form of foreign property. (ii) Positive net transfer of capital authorized by § 503, § 507 or § 1002. (iii) Positive net transfer of capital prohibited only if positive direct investment results. (iv) Allocation or reallocation to positive direct invest- ment deemed first to re- duce positive net transfer of capital. (v) Application to overseas finance subsidiaries. (vi) Specific exemption from the prohibitions of § 203 (d)(1). B304 — Affiliated Foreign Nationals § B304-1 Introduction. § B304-2 Summary. § B304-3 Requisite financial interest. § B304— 4 Foreign nationals. (i) Corporations. (ii) Partnerships. (iii) Business ventures. § B304— 5 Specific exceptions. § B304-6 Application of § 304. B305 — Direct Investor B306 — Direct Investment § B306-1 Introduction. § B306-2 Summary. § B306-3 Relation of § 306 to other sec- tions. § B306-4 Application of § 306. § B306-5 Basic definition and calculation of direct investment. § B306-6 Reinvested earnings of incorpo- rated AFNs. (i) Total earnings, (ii) DI's share of total earn- ings, (iii) Reinvested earnings. § B306-7 Deduction from positive direct investment: Allocated pro- ceeds of long-term foreign borrowing, (i) Recalculation of worldwide positive direct investment under § 503 and combined Schedules B/C positive di- rect investment under § 507. (ii) Relation to § 313(d)(1) deductions, (iii) Treatment of aggregate annual losses in recalculat- ing 1969 direct investment under § 503 by scheduled area, (iv) Apportionment by other methods. § B306-8 Calculation of direct investment during year of acquisition or disposition of interest in an AFN. B312 — Transfers of Capital § B312-1 Introduction. § B312-2 § B312-3 Summary. Valuation of transfers of capital. REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 5 B312^1 Acquisition of interest ir an AFN. (i) Equity financing. (ii) Contingent consideration. (Hi) Unincorporated AFNs. 5 B312-5 Acquisition of an AFN's debt obligation § B312-6 Contributions by a DI to capital of AFNs. I B312-7 Repayment of DI's indebtedness to an AFN. § B312-8 Reduction of an AFN's equity in- terest in a DI. 5 B312-9 Disposition of an equity or debt interest in a DI held by an AFN. § B312-10 DI's satisfaction of an AFN's debt obligation. § B3 12-11 Repayment of a DI's long-term foreign borrowing. § B312-12 Lease of property by a DI to an AFN. § B312-13 Inducements for loans to a DI or to an AFN. § B3 12-14 Indirect transfers by a DI to an AFN. § B3 12-15 Transfers of capital by an AFN to a DI. (1) Acquisition by AFN of in- terest in DI. (ii) Disposition by DI of in- terest In AFN. (iii) Accounts receivable. 5 B312-16 Sale of an AFN to an unaffiliated foreign national with deferred payment. § B312-17 Triangular and parallel financing. § B312-18 Certain transactions not In- volving a transfer of capital: § 312(c). § B3 12-19 TJnenumerated transactions not involving a transfer of capital. 5 B312-20 International construction proj- ects. B323 — International Finance Subsidiaries B324 — Long-Term Foreign Borrowing B313 — Net Transfer of Capital § B313-1 § B313-2 § B313-3 § B313-4 8 B313-5 § B313-6 5 B313-7 Introduction. Net transfer of capital to incor- porated AFNs. Net transfer of capital to unin- corporated AFNs. (I) General. (ii) Rules applicable to § 313 (b). DI's share of net change In assets under § 313(b). (i) Direct ownership. (Ii) Indirect ownership. Special treatment of certain § 312 transfers in computing net transfer of capital to unin- corporated AFNs. (i) Repayment of long-term foreign borrowing. (II) Transfers under § 312(a) (9). (ill) Offshore drilling rigs. Deduction for expended pro- ceeds of long-term foreign bor- rowing. Step acquisitions. B319 — Schedule A, B and C Countries B321 — Calendar Year and Fiscal Year B322 — Person Within the United States 8 B324-1 5 B324-2 8 B324-3 8 B324— 1 8 B324-5 8 B324-6 8 B324-7 8 B324-8 § B324-9 8 B324-10 8 B324-11 8 B324-12 8 B324-13 Introduction. Related sections. (i) Section 1002. (11) Section 203(c). (iii) Section 203(d) (1). (iv) Subpart N. Summary of 8 324. Definition of long-term foreign borrowing. (I) Borrowings made prior to January 1, 1968. (II) Borrowings made on or after January 1, 1968. and prior to June 10, 1968. (iii) Borrowings made on or after June 10, 1968: 5 324 (a)(1) and former 8 324 (e). (Iv) Borrowings made on or after May 1, 1970. Refinancing. (i) Refinancing under 8 324 (b)(1). (ii) Refinancing of long-term foreign borrowing made prior to May 1, 1970. Proceeds of long-term foreign borrowing. Available proceeds. Expenditure of available proceeds and deduction from net trans- fer of capital. Allocation of available proceeds. Allocation of expended proceeds and reallocation of previously allocated proceeds. Repayment of long-term foreign borrowing. Recordkeeping. Borrowings denominated in a foreign currency. B502 — Election of Allowables B503 — Worldwide Minimum Allowable § B503-1 8 B503-2 8 B503-3 8 B503-4 8 B503-5 8 B504-1 8 B504-2 8 B504-3 8 B504-4 1 B322-1 Introduction. 8 B322-2 Individuals, (i) Residence. (ii) Center of economic inter- est. 8 B504-5 8 B322-3 8 B322-4 Corporations or partnershlpa. Trusts. 8 B322-6 § B322-6 Estates. Domestic banks. 5 B504-6 8 B322-7 Special cases. 5B504-7 Introduction. Summary. Calculation of direct investment under 8 503. (i) Worldwide basis. (11) -Treatment of aggregate annual losses in 1969. (iii) Canadian AFNs. Carryforwards. Related provisions. (i) Available proceeds, (ii) Associated groups and per- sons owning interests in DIs. (iii) Quarterly reports, (iv) Apportionment of borrow- ing deduction. B504 — Schedular Allowables Introduction. Summary. Calculation of historical allow- ables under 8 504(a). Calculation of 8 504(b) earnings allowables and 8 504(c) earn- ings adjustment to 8 504(a) historical allowables, (i) Section 504(b) : 30 percent earnings allowables, (ii) Section 504(c): "Up- stream" use of allowables. Transfer or carryforward of schedular allowables. (I) Schedule A carryforward. (II) Schedule B downstream or carryforward. (ill) Schedule C downstream or carryforward. Total losses of Incorporated AFNs In "Schedule C. Related provisions. B505 — Transfers of Capital Between Affiliated Foreign Nationals § B505-1 Introduction. 8 B505-2 Summary. 8 B505-3 Transfers by or to unincorporated AFNs attributed to immediate parent. i B505-4 Treatment of transfers deemed made under 8 505(a)(1). 8 B505-5 Transfers between incorporated AFNs. 8 B505-6 Purchase and sale of interests in other AFNs. (1) Purchase of AFN. (ii) Sale of AFN. 8 B505-7 Transactions between AFNs not Involving transfers of capital. (1) Stock for stock transactions and reorganizations. (ii) Transfers of certain intan- gibles. (ill) Vessel charters. (Iv) Short-term trade credits between AFNs. 8 B505-8 Transactions between AFNs and their branches In different scheduled areas. 8 B505-9 Miscellaneous transactions. B506 — Incremental Earnings Allowable 8 B506-1 Introduction. § B506-2 Summary. 8 B506-3 Calculation of incremental earn- ings allowable. § B506-4 Application of the 8 506 allowable. 8 B506-5 Carryforward of the 8 506 allow- able. 8 B506-6 Miscellaneous. B507 — Alternative Minimum and Schedule A Supplemental Allowable 8 B507-1 Introduction. 8 B507-2 Application of the § 507 allow- able. 8 B507-3 Related provisions. B801 — Applications for Specific Authorizations or Exemptions or for Interpretive Opinions 8 B801-1 Introduction. § B801-2 Procedures. 8 B801-3 Particular authorizations or exemptions. B900 — Subpart I (5 5 901-907) 5 B900-1 8 B901-1 5 B902-1 8 B903-1 § B904-1 5 B905-1 i B906-1 8 B906-2 Introduction. Definition of direct interest. >(lj Direct Interest in a cor- poration, (ii) Direct interest in' unin- corporated business ac- tivities. Definition of indirect Interest. Definition of affiliate. (1) Consequences of being an affiliate, (ii) Definition of affiliated group, (ill) Treatment of members of an affiliated group as a single person. Definition of family group. Definition of associated group, (i) Acting in concert pursuant to an agreement or under- standing, (ii) Aggregate 10 percent in- terest, (ill) Members of associated group as separate DIs. (iv) Associated group invest- ment under 88 503 and 507. (v) Related AFNs. (vl) Effect of 8 505. (vll) Reporting. Ownership of DIs. Persons deemed acting for or on behalf of a DI. REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS § B906-3 Election under § 906 (b)(1). (i) Conditions for making election. (ii) Procedure for making election. (iii) Effect of election. (iv) Election by affiliated groups. (v) Limitation on use of § § 503 and 507 by con- senting owners. § B907-1 Reporting. (i) Consenting owners. (ii) Nonconsenting owners and owners of indirect in- terests. (iii) Associated groups. (iv) Affiliated and family groups. B1000 — Subpart J (§§ 1001-1003) § B1000-1 § B1001-1 « B 1001-2 § B1001-3 § B1001-4 § B1002-1 Introduction. Definition of borrowing by a DI and by an APN. Borrowing by a business venture APN. Definition of guarantee. DI's guarantee of an APN bor- rowing. Authorization of positive direct investment attributable to repayment of certain bor- rowings, (i) Preprogram guarantee of APN borrowing, (ii) Repayment of APN bank borrowing made or com- mitted prior to January 1, 1968. (iii) Repayment of AFN bor- rowing pursuant to guar- antee made in the period January 1, 1968, through June 9, 1968. (iv) Repayment of a long- term foreign borrowing made prior to January 1, 1968. (v) Repayment of a long- term foreign borrowing made in the period from January 1, 1968, through June 9, 1968. (vi) Repayment through con- version of debt obliga- tions into stock of DI. (vii) Guarantee made on or after June 10, 1968. (viii) Repayment of long- term foreign borrowing made on or after June 10, 1968. Standard Certificate Form FDI- 106. (i) Item I. (ii) Item II. (iii) ItemlV. (iv) Item V. (v) Item VI. Certification with respect, to convertible debt. Effect of transfers of capital in repayment of borrowings. ( i ) The repayment charge, (ii) Reduction of allowables, (iii) Reduction of allowables under § 507. B1100 — Subpart K (§§ 1101-1107) § Bl 100-1 Introduction. § B1101-1 Canadian APNs and non-Cana- dian Schedule B APNs. § Bl 102-1 Authorized positive direct in- vestment in Canadian APNs. (1) Calculation of positive di- rect investment in Can- ada (§§ 1103-1104). § Bl 105-1 Canadian foreign balances. § B1002-2 § B1002-3 § B1003-1 § B1106-1 Long-term foreign borrowing from Canada, (i) Public offerings prior to April 1, 1968. (ii) Public offerings on or after April 1, 1968. B1300 — Subpart M (§§ 1301-1303) § B1300-1 Introduction. § B1301-1 Exclusions from transfers of capital. § B1302-1 Earnings allowable for foreign air transport operations, (i) Aggregate annual for- eign air transport earn- ings, (ii) Relation of § 1302 to § 504. (iii) Carryforwards, (iv) Repayment charges un-' der § 1003. § B1302-2 Reporting. § B1303-1 Coordination of §§ 504, 506, and 1302. B1400 — Subpart N (§§ 1401-1405) § B1400-1 Introduction. § B 1401-1 Definitions. § B1402-1 Qualification. § B1403-1 Transfers of overseas proceeds; foreign balances. § B1404-1 Repayment of overseas borrow- ing and proceeds borrowing. § B1405-1 Authorized repayments. Appendix Revised Instructions for Submitting Appli- cations for Specific Authorizations or Ex- emptions or for Interpretive Opinions (Sept. 11, 1970). The appendix to this Bulletin was not filed with the Office of the Federal Register. The material contained in the appendix was is- sued on the date indicated and distributed by OPDI to DIs and other interested persons. The appendix will be included in the reprint of this 1970 General Bulletin to be issued by OFDI following publication in the Federal Register. Introduction General. This 1970 General Bulletin is designed to provide a reliable and authoritative source of information concerning in- terpretation and application of the regu- lations as in effect for 1970. The program is administered on a calendar year basis, and a number of amendments to the regulations have been made for 1970. In connection with questions arising under the regulations as in effect during 1968 and 1969, direct investors (DIs) should refer to General Bulletins Nos. 1 and 2 (33 F.R. 15158 and 15834) and to the 1969 General Bulletin (34 F.R. 17806). However, examples in this 1970 Bulletin illustrating transactions occur- ring in 1968 or 1969 are dispositive of the same questions under the 1970 regula- tions, unless expressly indicated that the transaction involves only the regulations as in effect for 1968 or 1969. Program changes in 1970. The following are the major changes made in the program for 1970: (i) Section 507 alternative minimum and Schedule A supplemental allowable. Section 507 provides a new direct invest- ment allowable that DIs may elect start- ing in 1970. The § 507 allowable consists of a $1 million modified worldwide al- lowable (alternative minimum allow- able) and a supplemental allowable of $4 million for use in Schedule A. (ii) Section 506 incremental earnings allowable. Originally promulgated in 1968, the incremental earnings allowable may be used for making direct invest- ment commencing in 1970. (iii) Elimination of aggregate annual loss rule in § 503. DIs electing the § 503 worldwide minimum allowable are no longer required to disregard "aggregate annual losses" as was required in 1969. (iv) Liberalization of Schedule C his- torical allowable. The § 504* a) historical allowable in Schedule C is no longer sub- ject to the limitation imposed by the "reinvestment ratio" alternative method of computing such allowable. (v) Conditions for making long-term foreign borrowing. Starting May 1, 1970, DIs have greater flexibility in making borrowings that will qualify as long- term foreign borrowing. In general, under amended § 324 a long-term for- eign borrowing is foreign borrowing that is in fact outstanding (including re- financing thereof) for a period of at least 12 months. A revised standard certificate Form FDI-106 has been issued for Subpart J certification of borrowings made on or after May 1, 1970 pursuant to amended § 324. (vi) General treatment for overseas finance subsidiaries. During 1968 and 1969 OFDI specifically authorized DIs, in effect, to treat as proceeds of long-term foreign borrowing funds borrowed long- term by an overseas finance subsidiary (OFS) from sources outside the United States and Canada. New Subpart N makes this treatment generally available without the necessity of obtaining spe- cific authorization. Summary of the regulations. The regulations contain the operative rules of the Program, the principal fea- tures of which are discussed in general terms below. (i) Applicability. The regulations ap- ply to "direct investors." A DI is any person (whether an individual or a busi- ness entity) within the United States that owns or holds a 10 percent or greater interest in an incorporated or unincorporated foreign entity (§ 305). A foreign entity in which such interest is owned or held is referred to as an "affil- iated foreign national" ("AFN") <§ 304) . Interest in an AFN is measured by vot- ing power in the case of a corporation and by the right to a share of profits in the case of an unincorporated enter- prise ( § 304(b) (2) ) . Persons may be DIs either in their individual capacity or by virtue of their relationships with other U.S. persons (§§903-906). The regula- tions specifically do not apply to banks or other financial institutions subject to the Voluntary Foreign Credit Restraint Program administered by the Board of Governors of the Federal Reserve Sys- tem (§ 201(b) (2)). (ii) Requirements and restrictions. Three fundamental requirements are imposed on all DIs : REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS The amount of annual direct Investment In AFNs must not exceed the level author- ized under the general allowables provided for In the regulations or the amount spe- cifically authorized by OFDI; The amount of certain foreign balances or other forms of foreign property must be restricted as specified in the regulations; and Reports reflecting allowables and trans- actions pertinent to foreign direct invest- ment activities must be filed with OFDI. DIs may seek relief from a particular restraint imposed by the regulations through application to OFDI for specific authorizations or exemptions (§ 801). A DI making foreign direct investment in excess of that authorized either gen- erally under the regulations or specifi- cally by OFDI, or otherwise violating the program restrictions, is subject to enforcement proceedings. Noncompli- ance with the requirements of the regu- lations may give rise to imposition of sanctions, either criminal or acuninis- trative (§§ 201(d) and 701). Rules and procedures concerning the enforcement function of OFDI (including investiga- tions and administrative remedies) are contained in 15 CFR Parts 1020-1050. (iii) Calculation of direct investment. Direct investment by a DI is calculated on a calendar year basis by adding the DI's net transfer of capital to AFNs and the DI's share of earnings reinvested by incorporated AFNs (§ 306(a)). "Net transfer of capital" means (a) aggregate transfers of capital by a DI to incorporated AFNs during the year, less (b) aggregate transfers of capital by incorporated AFNs to the DI during the same period, plus (c) the DI's share of net increase or decrease in net assets of unincorporated AFNs (§313). A transfer of funds or other property that increases a DI's aggregate equity and debt investment in an AFN is generally a transfer of capital by the DI to the AFN (§ 312(a)). A transfer of funds or other property that decreases a DI's in- vestment in an AFN is generally a trans- fer of capital by the AFN to the DI (§ 312(b)). In computing a DI's trans- fers of capital and net transfer of cap- ital, special rules apply to transactions between a DI's AFNs that are located in different scheduled areas (§ 505). "Reinvested earnings" means (a) total earnings (defined in § 306(c)) of in- corporated AFNs, less (b) dividends paid by incorporated AFNs to the DI and certain other AFNs, plus (c) dividends and remittances received by incorporated AFNs from certain other AFNs (§ 306 (b)). For purposes of the regulations, each of the countries of the world is assigned to one of three "scheduled areas" XA, B, and C) (§ 319). Direct investment of a DI is generally calculated on the basis of these scheduled areas, reflecting aggre- gate transactions involving all AFNs located in each such area (§§ 306 and 313) . Schedule A generally comprises the less-developed countries; Schedule B, certain specified developed countries; and Schedule C, the remaining countries. For certain purposes,- however, direct investment allowables may be used on a worldwide rather than a schedular basis (§§503 and 506; see also Subpart M). (iv) Authorized direct investment. Positive direct investment in AFNs is prohibited except to the extent that it is authorized either generally under the regulations or individually by specific authorization (§§ 201(a) and 801). Subpart E (§§501-507) provides four direct investment allowables, one of which a DI must elect for each year (§ 502) : A worldwide minimum allowable of $1 million (§ 503); An historical allowable for eacn scheduled area based on direct investment in each such area by the DI during 1965-66 (§ 504 ■(a)); An earnings allowable for each scheduled area based on the DI's share of AFN earn- ings in each such area during the preceding year (§ 504(b) ); and A $1 million alternative minimum allow- able for use in Schedules B and C and a $4 million supplemental allowable for use in Schedule A (§507). In general, the unused portion of an al- lowable (other than the §§50S and 507 allowables) may be carried forward to succeeding years (§§ 504 (d) and (f) and 506(d)). Historical allowables in Schedule C or B are increased by a limited "upstream" redistribution (§ 504(c)). 1 The historical or the earnings allowables provided in § 504 and the $1 million Schedule B/C allowable provided in § 507(a)(1) may be used "downstream" (§§ 504(d) and 507(b)). Commencing in 1970, DIs are eligible for a worldwide "incremental earnings" allowable (in addition to one of the fore- going allowables) based on the amount by which aggregate AFN earnings in a calendar year exceed the average of such earnings during 1966-67 (§ 506) . Because of considerations unique to the airlines industry, special rules for com- puting authorized direct investment for U.S.-flag air carriers are provided in Subpart M. Although Canada is assigned to Sched- ule B, the regulations do not restrict direct investment made or liquid foreign balances held in that country (Subpart K). (v) Long-term foreign borrowing. In general, direct investment in AFNs that is financed with or offset by proceeds of long-term foreign borrowing (defined in § 324) will not involve use of the DI's allowables until the borrowing is repaid. "Available proceeds" of long-term for- eign borrowing (di fined in § 324(d) ) may te used as a deduction against a DI's net transfer of capital if expended in making transfers of capital (§ 313(d) (1)), or as an offset to positive direct investment if "allocated" in accordance with certain prescribed conditions (5 306(e) ). Proceeds that have been ex- pended may subsequently be allocated and allocated proceeds may later be re- allocated as an offset to positive direct investment in a different scheduled area (§ 203(d) (2) and (3)). 1 "Upstream" and "downstream" refer to the relationship of one scheduled area to an- other. The upstream sequence is Schedule A, Schedule B. and Schedule C. The downstream sequence is Schedule C, Schedule B, and Schedule A. Repayment of long-term foreign bor- rowing is generally authorized by § 1002 if the DI satisfies the applicable certifi- cation, recordkeeping and reporting re- quirements (Subpart J) . DIs electing a § 504 allowable may not make a positive net transfer of capital (other than one attributable to repay- ment of long-term foreign borrowing au- thorized by § 1002) resulting in positive direct investment while holding available proceeds of long-term foreign borrowing in excess of $25,000 in the form of for- eign property (§ 203(d) (1) ). Subpart N (§§ 1401-1405) provides rules for the treatment of borrowings by an AFN that qualifies as an overseas fi- nance subsidiary (OFS). Funds received by an OFS from "overseas borrowing" may be transferred to other AFNs of the DI without recognition of any transfers of capital under § 505. Moreover, pro- ceeds of overseas borrowing lent by the OFS to the DI may be treated as avail- able proceeds of long-term foreign bor- rowing and, accordingly, may be used to offset positive direct investment in any scheduled area. (vi) Foreign balance restrictions. The regulations restrict the amount of assets that a DI may hold in liquid form in a foreign country other than Canada. In general, such balances may not exceed the greater of $25,000 or the average of month-end liquid foreign balances held by the DI in 1965-66 (§203(0). (vii) Reporting requirements. DIs are required to keep records and to submit certain reports to OFDI (§§ 203(b), 601 and 602) . If the DI's interest in all AFNs is $100,000 or more or if the DI's AFNs have annual earnings of $50,000 or more, a Base Period Report (Form FDI-101) of direct investment by scheduled area during 1965-67 (and 1964 earnings for Schedule C) must be submitted, and an Annual Report (Form FDI-102F or ab- breviated Form FDI-102F/S) is required to be filed within 4 months after the end of each calendar year. In addition, a DI must file Cumulative Quarterly Reports (Form FDI-102) beginning in the quar- ter that direct investment (positive or negative) exceeds $1 million for the year. In calculating direct investment to de- termine whether the quarterly reports are required, a DI must include direct investment in Canada and exclude de- ductions for expenditure or allocation of proceeds of long-term foreign borrowing. Special rules apply to reporting by DIs that are members of an affiliated, family, or associated group or are owners of other DIs (§907). Additional comments. As used in this Bulletin, the terms "OFDI" and the "Office" refer generally to the Office of Foreign Direct Invest- ments, but may also be used, for the sake of convenience, to include the Secretary of Commerce and all other persons to whom any function, duty or authority re- ferred to in Executive Order 11387 or in the regulations has been delegated pur- suant to Department Order 184-A (is- sued on Jan. 1, 1968), Department Or- der 184-B (as amended) or § 806 of the regulations. REPRINTED FROM FEDERAL REGISTER, VOL. 35. NO. 195- WEDNESDAY, OCTOBER 7. 1970 RULES AND REGULATIONS Examples in this Bulletin involving transactions in years subsequent to 1970 are intended for illustrative purposes only, and no inference should be drawn concerning the actual amount of Sub- part E and M allowables that will be available in such years. In submitting certificates described in § 1002(b), how- ever, a DI may assume that general al- lowables in future years will not be less than the amounts applicable for the year in which the certificate is filed. B201 — Prohibited Direct Investment § B201-1 Introduction. Section 201 sets forth the basic prohibitions on direct investment and the regulatory authority of OFDI, as derived from Executive Order 11387 of January 1, 1968. The section covers: General prohibition of positive direct investment (§ 201(a)); exclusion of financial institutions subject to the Voluntary Foreign Credit Restraint Pro- gram administered by the Board of Gov- ernors of the Federal Reserve System (§ 201(b) (2) ) ; exclusion of transactions arising from a foreign national's interest in a U.S. business (§201(0); and discretionary conditions or sanctions (§ 201(d)). § B201-2 General prohibition. Section 201(a) prohibits a DI from making positive direct investment in AFNs during any year, beginning with the effective date of the regulations (Jan. 1, 1968), subject to express au- thorization for certain kinds and amounts of positive direct investment set forth in Subpart E (general allow- ables) , Subpart J .(repayment of borrow- ings), Subpart K (direct investment in Canada), and Subpart M (U.S.-flag air carriers) . In addition, OFDI may permit other transactions by means of specific authorizations or exemptions, as pro- vided in § 801. The prohibition of § 201(a) is ad- dressed to "positive direct investment (a technical term defined in 1306(a)(3)) during any year." This does not mean that specific transactions between a DI and an AFN are prohibited; rather, the focus is on the net effect of all trans- actions during a year, measured at yearend. The term "year" normally means a calendar year. However, in certain cir- cumstances, a DI may be specifically au- thorized to measure compliance with § 201(a) on the basis of a fiscal year. (See § 321.) Example 1. DI has a wholly owned Incor- porated AFN (C) In Germany. During 1969, DI loans $1,200,000 to C. The loan does not violate § 201(a) at the time it is made, al- though the transaction constitutes a trans- fer of capital under § 312(a) and will be taken into account in determining the amount of direct investment made by DI in all APNs in Schedule C for the entire year. Exam-pie 2. DI is authorized by § 504 (a) and (c) , to make positive direct investment of $1,500,000 in Schedule A during 1969. Be- tween January 1, and December 31, 1969, DI's positive direct investment in that scheduled area is $1,700,000. DI is out of com- pliance (i.e., has violated §201 (a)) ir the amount of $200,000. § B201-3 Exclusions. (i) Financial institutions. Under the terms of Executive Order 11387, and as provided in § 201(b) (2), banks and non- bank financial institutions are exempt from the regulations if they are sub- ject to the Voluntary Foreign Credit Restraint Program administered by the Board of Governors of the Federal Re- serve System. Included in this category are commercial banks, bank holding companies, savings banks, trust com- panies and trust departments of banks, insurance companies, mutual funds, fi- nance companies, investment bankers and brokers, pension funds, foundations and other nonprofit institutions, "Edge Act" and "Agreement" subsidiaries of commercial banks, and U.S. branches of foreign banks or nonbank financial in- stitutions. The Federal Reserve Program calls upon such institutions to refrain from making loans or extending credit to U.S. borrowers that would "directly or indirectly" permit an outflow of funds inconsistent with the provisions and in- tent of the OFDI Program or making loans to foreign affiliates substituting for credit that might otherwise have been obtained abroad. U.S. investment companies owning or establishing offshore mutual funds are subject to the Federal Reserve Program, whereas U.S. individuals owning or es- tablishing foreign banks or nonbank fi- nancial institutions are subject to OFDI. Also, independent leasing com- panies and leasing affiliates of manufac- turing companies are generally not included as nonbank financial institu- tions subject to the Federal Reserve Program. If a U.S. financial institution that is subject to the Federal Reserve Program acquires a nonfinancial enterprise which is a DI, OFDI will continue to regulate the direct investment activities of the acquired company, and separate report- ing requirements for parent and sub- sidiary will be maintained. (ii) Transfers of capital to foreign owners. The regulations do not restrict bona fide transfers of capital or distri- bution of earnings to a foreign national arising from the foreign national's own- ership interest in a U.S. entity. Example 3. A U.S. corporation (X) is 50 percent owned by an Italian corporation ( Y) . Y is publicly owned by foreign na- tionals. During 1969, Y purchases $500,000 of goods on credit from X, and X pays Y a divi- dend of $100,000. During 1970, X is liquidated and a liquidating dividend is paid to Y. The transactions are not subject to the regulations. § B201— 4 Reduction of authorized direct investment or of period for measuring compliance. Section 201(d) authorizes OFDI to impose conditions on, or to reduce the amount of, authorized direct investment by a DI. Although direct investment is generally measured on an annual basis, § 201(d) gives OFDI the right to impose a shorter period for compliance purposes with respect to any DI. Section 201(d) provides authority for administrative action by OFDI where large outflows early in a year indicate that serious violations could occur unless remedial steps are taken. The section also contains authority for appropriate sanctions in flagrant instances of disre- gard for the objectives of the program, such as in the case of a company that temporarily makes a large reduction in foreign investments at the very end of a year (thereby producing literal compli- ance with the regulations for that year) and then offsets the reduction with a major reinvestment abroad in the begin- ning of the following year. 8203 — L*quid Fore;gn Balances _§.B203-1 Introduction. Section 203 limits the amount of funds or other liquid assets that a DI may hold abroad as of the end of each month. Section 203(c) requires DIs to repatriate to the United States "liquid foreign balances" (defined in § 203(a) (2)) in excess of specified historical levels for such holdings or $25,000, whichever is greater. An exception from the repatria- tion requirement is made for liquid foreign balances held in Canada (§ 1105 (b) ) , and for available proceeds of long- term foreign borrowing that are held in the form of liquid foreign balances (§ 203(c)). While § 203(c) refers to monthend holdings for purposes of the limitation on liquid foreign balances, it is intended that DIs should not exceed the permis- sible level throughout the month. Section 203(d) (1) generally prohibits a DI electing § 504 from making a posi- tive net transfer of capital if the DI holds available proceeds abroad as of yearend. The provisions of § 203 also apply to foreign balances and available overseas proceeds held by an overseas finance sub- sidiary (OFS). See § 1403(b). § B203-2 Summary. Section 203(a) defines the terms "foreign balances" and "liquid foreign balances" and provides that under cer- tain circumstances foreign balances held by another person will be deemed held by a DI. Section 203(b) requires a DI to keep books and records identifying proceeds of long-term foreign borrowings and the uses to which the proceeds of each such borrowing have been put. Section 203(c) limits the amount of liquid foreign balances (other than Ca- nadian balances or available proceeds of long-term foreign borrowing) a DI may hold at the end of any month to the greater of (1) average end-of -month balances held by the DI during 1965 and 1966 or (2) $25,000. While available proceeds held in liquid form outside the United States are not subject to the monthend balance re- strictions of § 203(c), there is a yearend restriction imposed by § 203(d) (1) . Posi- tive direct Investment, to the extent at- tributable to a positive net transfer of capital, will not be authorized to a DI electing § 504 if the DI holds available proceeds in the form of foreign balances or foreign property as of yearend. The REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS restriction of § 203(d) (1) does not apply if (a) the available proceeds do not ex- ceed $25,000; (b) the positive net trans- fer of capital resulted from debt repay- ment authorized by § 1002; or (c) the DI has elected for such year to be governed by either § 503 (minimum allowable) or § 507 (alternative minimum and Sched- ule A supplemental allowable) . It should be emphasized that available proceeds held in the form of Canadian foreign balances or other property are not ex- empt from § 203(d)(1). Section 203(d) (2) permits proceeds of long-term foreign borrowing that have been previously expended and deducted from net transfer of capital pursuant to § 313(d) (1) to be "allocated" to posi- tive direct investment in another sched- uled area. When expended proceeds are subsequently allocated, the DI must rec- ognize a positive transfer of capital to the scheduled area in which the § 313(d) (1) deduction was previously taken; further allocation will likewise result in a transfer of capital to the scheduled area to which the proceeds were last allocated. (For a more detailed analysis of § 203(d) (2) , see § 324-10.) Section 203(d) (3 permits a DI to real- locate proceeds of long-term foreign bor- rowing to offset positive direct invest- ment in a scheduled area other than that in which such proceeds were originally allocated. In such event, a transfer of capital is charged to the scheduled area to which the immediately preceding al- location was made. (For a more detailed analysis of § 203(d) (3), see § B324-10.) § B203— 3 Definition of foreign balances. The term "foreign balances" is denned In § 203(a)(1) to mean money on de- posit in a foreign bank (including de- mand, time and fixed interest deposits and certificates of deposit) ; negotiable instruments, nonnegotiable instruments acquired after June 30, 1968, and com- mercial paper issued by unaffiliated for- eign nationals (other than such instru- ments or paper acquired as a result of a DI's export of goods and services from the United States) ; and securities issued or guaranteed by a foreign country. The term "money on deposit in a for- eign bank" includes all bank deposits, whether interest-bearing or not, main- tained with a "foreign bank" as defined in § 317(b). The terms "negotiable instruments," "nonnegotiable instruments," "commer- cial paper," and "securities" include notes, bonds, debentures, drafts, bills of exchange, or other evidences of indebt- edness. The physical location of such evidences of indebtedness is immaterial. The term "securities issued or guaran- teed by a foreign country" includes debt securities issued or guaranteed by any governmental unit of a foreign country, i.e., the national government, states, cities, municipalities, counties, cantons, provinces, and the like. The physical lo- cation of such securities is immaterial. Equity interests do not constitute for- eign balances. Furthermore, items such as accounts receivable not evidenced by any note or security, precious metals, jewels, Jewelry, commodities futures contracts and currency futures contracts do not constitute foreign balances. § B203— 4 Definition of liquid foreign balances. As defined in § 203(a) (2), "liquid for- eign balances" do not include: Negotiable instruments, nonnegotiable in- struments, commercial paper and securities issued or guaranteed by a foreign country acquired on or before June 30, 1968 that are not redeemable at the option of the DI and are not transferable and readily marketable; Bank deposits, negotiable instruments, nonnegotiable instruments, commercial paper and securities issued or guaranteed by a foreign government that have a period of more than 1 year remaining to maturity when acquired by the DI and are not re- deemable in full at the option of the DI within a period of 1 year after such acquisition; Foreign balances subject to restrictions on liquidation and transfer imposed by a for- eign county (i.e., exchange controls or simi- lar restrictions); and Foreign balances pledged or hypothecated by the DI in connection with a borrowing by the DI or by an AFN or foreign bal- ances transferred by a DI to the extent of any transfer of capital recognized under § 312(a) (9). For purposes of § 203(a) (2) (iv) , for- eign balances are deemed pledged or hy- pothecated if, pursuant to an express or implied agreement, the DI may not withdraw such balances while the bor- rowing involved remains outstanding. The exclusion under § 203(a) (2) (iv) does not apply to any amount pledged or hypothecated in excess of the amount of the related borrowing by the DI or by an AFN. Example 1. DI obtains a 3 -year loan of $200,000 from a foreign bank and immedi- ately expends the proceeds in an AFN. As a condition of obtaining the loan, DI is re- quired to keep $40,000 on deposit with the foreign bank during the 3 -year term. As- suming the loan constitutes a long-term for- eign borrowing (as defined in §324), this arrangement involves a $40,000 transfer of capital to the AFN in addition to the $200,000 transfer of capital resulting from investment of the loan proceeds. (See § 312 (a) (9) and I B312-13.) Consequently the $40,000 deposit is not a liquid foreign balance. Example 2. DI enters into an arrangement with a foreign bank pursuant to which DI deposits $100,000 with the bank and the bank immediately lends $100,000 to an AFN. This arrangement involves a $100,000 trans- fer of capital to the AFN. (See § 312(a) (9) and § B312-13.) The $100,000 deposited by DI Is not a liquid foreign balance. Example 3. DI has a 25 percent Interest in a Swiss bank. In July 1970, DI deposits $100,000 with the bank to provide it with additional working capital. The deposit will not be considered a liquid foreign balance under § 203(c) , but will constitute a transfer of capital under § 312(a) (2). § B203— 5 Foreign balances deemed beld by a DI. Section 203(c) comes into effect if liquid foreign balances are "held" by a DI. A DI holds foreign balances if it has title to the securities, instruments or rights that are included within the meaning of the term, as defined in § 203(a)(1). In addition, § 203(a) (4) establishes circumstances in which a DI is deemed to hold foreign balances even though title is vested in another person. Sub- paragraph (i) imputes foreign balances to a DI if they are held by any person (including an AFN) "principally formed or availed of by the DI for the purpose of holding title to such balances"; i.e., a DI having the real beneficial interest in foreign balances will be deemed to hold such balances notwithstanding that an- other person has nominal legal title. Example 4. DI forms an incorporated AFN and transfers liquid foreign balances to it. The AFN does not engage in any business other than holding liquid foreign balances. Such balances are deemed to be held by DI under § 203(a) (4) (i). (Note that the trans- fer also constitutes a transfer of capital from DI to the AFN, pursuant to § 312 (a)(2).) Example 5. DI enters into an arrangement with an unaffiliated foreign national where- by the latter will hold title to DI's liquid foreign balances but will not use the funds itself. The liquid foreign balances are deem- ed to be held by DI under § 203(a) (4) (i). Subparagraph (ii) of § 203(a) (4) im- putes foreign balances to a DI even though title is held by another person (including an AFN) , if the balances (or cash equivalent) are returnable to the DI on demand without material condi- tions and they are not reasonably re- lated to the business needs of the holder. Foreign balances are not deemed return- able to a DI upon demand without mate- rial conditions merely because, by virtue of stock ownership, the DI controls tbe person holding title. Example 6. DI has an incorporated AFN (A) engaged in manufacturing operations. From 1960 through 1968, A earned $10 mil- lion and on June 30, 1969 has $8 million Invested in 6-month certificates of deposit of foreign banks. No part of these funds is needed by A to meet business requirements. Nevertheless, the foreign balances are not deemed to be held by DI, since they are not considered to be returnable to DI upon de- mand without material conditions. On the other hand, assume that on June 1, 1969, A declared a $500,000 dividend in favor of DI and such dividend became payable on demand on June 15, 1969. In this event, $500,000 of the $8 million are deemed liquid foreign balances held by DI as of June 30, 1969. Note also that, since the dividend was not paid when due, a debt obligation is deemed to have been created in favor of DI resulting in a $500,000 transfer of capital by DI to A under § 312(a) (1) . Accordingly, pay- ment of the past due dividend will consti- tute a transfer of capital from A to DI pur- suant to § 312(b) (3). Example 7. DI has 50 percent interest in a German company (C) . In June 1969, DI lends $100,000 to C, repayable on demand. The $100,000 is invested by C in a 6-month cer- tificate of deposit of a foreign bank. C does not need any part of the $100,000 to meet business requirements. The certificate of de- posit is deemed to be held by DI. (Note "also that the loan would constitute a transfer of capital from DI to C pursuant to § 312(a) (1).) Determining whether liquid foreign balances held by an AFN are "unrelated to the business needs" of the AFN re- quires analysis of all facts and circum- stances of the particular case. The na- ture of the AFN's business and customary holdings of liquid funds are relevant fac- tors. As a general rule, liquid foreign bal- ances held by an AFN will not be consid- REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS ered unrelated to its business needs if re- quired to pay current operating expenses (including tax, royalty, interest, and similar obligations), to pay for reason- ably current or planned capital improve- ments or additions, or as standby con- tingency reserves. Example 8. DI has a wholly owned sub- ■sidiary in Mexico (A) engaged in manufac- turing operations. A holds $1 million in liquid foreign balances as of June 30, 1969, of which only $250,000 may reasonably be re- quired for working capital purposes. How- ever, A has entered into a contract for ex- pansion of facilities and plans to expend the remaining $750,000 in 1969 and 1970 for this purpose. The liquid foreign balances held by A are, therefore, related to business needs and are not treated as liquid foreign balances of DI under § 203(a) (4) even if returnable to DI upon demand without material con- ditions. Example 9. DI has a wholly owned sub- sidiary (C) in Germany engaged in manu- facturing operations. As of June 30, 1969, C holds liquid foreign balances of $1 million. C requires only $250,000 of this amount for working capital purposes, and intends to lend the remaining $750,000 from time to time to other APNs on a short-term basis. Accordingly, $750,000 of the liquid foreign balances held by C are unrelated to its busi- ness needs and will be treated as liquid foreign balances of DI under § 203(a) (4) (ii) if they are returnable to DI upon demand without material conditions. Although a DI may have nominal title to foreign balances used by an unincorpo- rated AFN for its ordinary business op- erations, the DI will be deemed to hold such balances only if the conditions of § 203(a)(4) are met. Example 10. DI has a branch in the United Kingdom (B) engaged in manufacturing op- erations. For many years, B has maintained an account averaging $500,000 with a local bank. As of June 30, 1969, B's account with the local bank has a balance of $500,000, related to its business needs. Thus, although the $500,000 is deemed returnable to DI upon demand without material conditions because B is a branch, the liquid foreign balances are not attributable to DI under § 203(a) (4) . Example ll.Ttl has a branch in the United Kingdom (B) engaged in manufacturing op- erations. For many years, B has maintained an account averaging $500,000 with a local bank. However, as of June 30, 1969, B's bal- ance in the account is $1 million. B has recently been expanding business at a rapid pace and estimates that, for the remainder of 1969 and thereafter, it will have to maintain cash balances of at least $1 million in order to meet increased operating commitments. The liquid foreign balances held by B are related to business needs and, therefore, are not treated as liquid foreign balances of DI under § 203(a) (4), even though returnable to DI upon demand without material con- ditions. Example 12. An individual (X) who is a "person within the United States" owns a substantial apartment house complex in France. As a result, X is a DI and the apart- ment house complex is his AFN. X also owns a chalet in France purchased principally for his own personal use, although he and his family reside there only from June through August each year. During the remainder of the year, X and his family reside in the United States and the chalet is rented on a month-to-month basis to others. The chalet is not an AFN of X X maintains two demand accounts with French banks. The funds In one account (ac- count No. 1), consisting principally of the income earned from the apartment house complex, are needed and utilized to pay the operating expenses of the apartment house complex and for repairs and improvements to this property. Operating expenses of the chalet and the cost of repairs and improve- ments to this property are paid out of the second account (account No. 2), but the principal use of this account is for X's per- sonal expenses when he resides in France. The funds in account No. 1 are not liquid foreign balances of X, as they are related to the business needs of X's AFN (i.e., the apartment house complex) ; the funds in ac- count No. 2 are liquid foreign balances of X, since their principal use is not for business needs. Foreign balances held in liquid form by an OFS are to be included in the com- putation of liquid foreign balances held by a DI for purposes of § 203(c). See § 1403(b). § B203— 6 Valuation of foreign balances. Negotiable instruments, nonnegotiable instruments, commercial paper and securities constituting foreign balances shall be valued, for purposes of § 203, at fair market value, or, if fair market value is not readily determinable, at the cost of acquisition. In the case of items the prices of which are quoted on a daily basis, the final bid price (or the closing sale price, if available) on the relevant date will be considered the fair market value on such date. Foreign balances in the form of bank deposits or other claims denominated in a foreign currency are valued at the cur- rent exchange rate in terms of U.S. dollars. § 15203—7 Limitation on amount of liq- uid foreign balances. Section 203(c) requires a DI to limit the amount of liquid foreign balances (other than Canadian foreign balances and available proceeds of long-term for- eign borrowing held in the form of liquid foreign balances) held as of the end of any month to the greater of (1) average end-of -month amounts held during 1965 and 1966 (i.e., the sum of liquid foreign balances held on the last day of each month during 1965 and 1966 divided by 24) or (2) $25,000. As provided by §§ 203(c) and 1105(b), Canadian foreign balances are not sub- ject to the limitations of § 203(c) and can be held by a DI (or an AFN) without restriction on amount (subject, however, to the yearend repatriation requirement in § 203(d) (1) for available proceeds held in the form of liquid foreign balances). Section 1105(b) excludes Canadian balances from the calculation of total liquid foreign balances for purposes of the $25,000 exemption under § 203(c) (2) . The parenthetical reference to "direct investment liquid foreign balances" in § 1105(b) is intended merely to reflect the exclusion of available proceeds of long-term foreign borrowing (as defined in § 324(d) ) from the restrictions of § 203(c) . It is not the intention of § 1105 (b) to authorize inclusion of available proceeds held in Canada during 1965 and 1966 for purposes of calculating average end-of-month liquid foreign balances under § 203(c). Section 203(c) also permits a DI to hold available proceeds of long-term foreign borrowing in the form of liquid foreign balances subject only to the limi- tation in § 203(d) (1) . "Proceeds of long- term foreign borrowing" and "available proceeds" of long-term foreign borrow- ing are defined in § 324 (c) and (d). Calculations under § 203 'c) are to be made on a worldwide rather than on a schedular basis. Accordingly, a DI may transfer liquid foreign balances from one foreign country to another, but the ag- gregate amount held abroad at the end of any month may not exceed the amount permitted by § 203(c) . Example 13. DI held liquid foreign bal- ances (other than Canadian foreign balances and available proceeds of long-term foreign borrowing) of $200,000 on March 31, 1965, $200,000 on April 30, 1965, $100,000 on May 31, 1965, $400,000 on April 30, 1966, and $300,000 on May 31, 1966. DI held no liquid foreign balances of any kind as of the end of any other month during 1965 or 1966. Therefore, DI may hold $50,000 of liquid for- eign balances (other than Canadian liquid foreign balances and available proceeds of long-term foreign borrowing held in the form of liquid foreign balances) as of the end of any month commencing June 30, 1968 (i.e., $1,200,000 divided by 24). Example 14. DI did not hold any liquid foreign balances during 1965 or 1966. Never- theless, DI may hold up to $25,000 in liquid foreign balances (other than Canadian liquid foreign balances and available proceeds held in the form of liquid foreign balances). See § 203 (c) (2). Example 15. DI held liquid foreign bal- ances during 1965 and 1966, but all were Canadian foreign balances. DI may not hold more than $25,000 of liquid foreign balances (other than Canadian liquid foreign bal- ances and available proceeds held in the form of liquid foreign balances) as of the end of any month. Only available proceeds of long-term foreign borrowing (i.e., borrowings re- ported on appropriate records and OFDI reporting forms, the proceeds of which have not been expended or allocated) and proceeds of foreign borrowing made on or after May 1, 1970 in anticipation of refinancing another foreign borrow- ing or long-term foreign borrowing (see §B324-5(i)) may be held in the form of liquid foreign balances outside the limitations of 203(c). Note, however, that if a DI does not properly report the borrowing as a long-term foreign bor- rowing, then the funds received, if held as liquid foreign balances, will be sub- jet to the restrictions of 203(c). (See §§ B203-8(i) and B324-6 and 7.) Once available proceeds are either ex- pended in making transfers of capital (and deductions taken under §3J3(d) (1)) or are allocated to offset positive direct investment pursuant to § 306(e), such funds cease to be available pro- ceeds and will not qualify for the ex- emption contained in § 203(c). More- over, § 306(e) provides that available proceeds allocated to positive direct in- vestment may not thereafter be held in the form of foreign balances or foreign property, liquid or otherwise. Example 16. On May 1, 1969, DI nego- tiates a $1 million long-term foreign bor- rowing, the proceeds of which are placed in a demand deposit with a London bank. The REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7. 1970 8 RULES AND REGULATIONS proceeds are available proceeds of long-term foreign borrowing, and may be held in the form of liquid foreign balances outside the limitations of § 203(c). On June 1, 1969, DI withdraws $600,000 from the London bank and loans the funds to a French AFN (C) on a 60-day note. The loan is a transfer of capital from DI to C, but since proceeds of long-term foreign borrowing were used, an amount equal to the transfer of capital must be deducted under § 313(d)(1). In July 1969, C repays the $600,000 loan. DI now holds $600,000 of proceeds of long-term foreign borrowing that are not available proceeds of such borrowing since they were expended in making the loan to C. There- fore, if the $600,000 is again placed on de- posit with the London bank, it would have to be included In the computation of liquid foreign balances held by DI under § 203(c). On De»ember 30, 1969, DI withdraws $400,000 from the London bank and repatriates the funds to the United States for the purpose of allocating such proceeds to positive direct Investment in Schedule B pursuant to § 306 (e). If the criteria of § 306(e) for allocation are met, the $400,000 could not thereafter be held In the form of foreign balances or any other foreign property. Example 17. During 1970, DI's interna- tional finance subsidiary issues $30 million of debentures convertible into the stock of the DI. The borrowing qualifies as long-term foreign borrowing under § 324 and DI re- ceives $29 million, after payment of under- writing and legal expenses, which DI de- posits in a foreign bank. Since DI has $30 million of available proceeds under § 324, DI may transfer $1 million of funds to the bank account and designate (on its books and records reflecting proceeds of long-term foreign borrowing) such funds as available proceeds for purposes of § 203(c). Note that the funds so designated will be treated as available proceeds for all purposes of the regulations, including § 203(d) (1) . § B203-8 Available proceeds of long- term foreign borrowing: Effect on positive net transfer of capital. Section 203(d) (1) prohibits a DI that elects a § 504 allowable pursuant to § 502 and holds more than $25,000 of available proceeds of long-term foreign borrowing in the form of foreign property at year- end from making a positive net transfer of capital to any scheduled area, to the extent such positive net transfer of capi- tal would result in positive direct invest- ment for such year, unless the positive direct investment is authorized by § 1002. Section 203(d) (1) does not apply to DIs electing the § 503 or § 507 allow- ables. The effect of § 203(d)(1) is to require use of available proceeds of long- term foreign borrowing, in whatever form held, for direct investment pur- poses before such investment is financed with funds from U.S. sources. For purposes of § 203(d) (1), a DI need not take into account positive direct in- vestment that occurs by reason of inter- schedular transfers of capital charged against an allowable "downstreamed" pursuant to § 504(d) . Under § 505, trans- fers of capital between APNs in different scheduled areas are attributed to the DI. Under § 504(d), a DI is permitted to "downstream" unused schedular allow- ables without limitation. Accordingly, circumstances may arise where, by rea- son of § 505, positive direct investment charged to a DI in a scheduled area will be authorized only by application of § 504(d) . If, as of yearend, the DI holds available proceeds, such positive direct investment would be prohibited by a lit- eral application of § 203(d) (1) . However, OFDI construes § 203(d) (1) as being in- applicable to positive direct investment arising from a § 505 transfer of capital that is charged against a DI's § 504(d) allowable. (i) Available proceeds held in the form of foreign property. The prohibitions of § 203(d) (1) apply during any year only if the DI holds available proceeds of long- term foreign borrowing in the form of foreign balances or other foreign prop- erty as of the end of such year. The term "available proceeds of long-term foreign borrowing" is defined in § 324(d) to mean the proceeds of long-term foreign bor- rowing remaining after deducting (a) amounts expended in making transfers of capital to AFNs (other than Canadian AFNs) and deducted from net transfer of capital under § 313(d)(1) and (b) amounts allocated to and deducted from positive direct investment in any sched- uled area (other than positive direct investment in Canada) under § 306(e) . If a DI does not report a long-term foreign borrowing on all required periodic re- ports following the borrowing, the pro- ceeds cannot be treated as available pro- ceeds and, therefore, are not subject to the prohibitions of § 203(d)(1). (See § B324-6 and 7.) Note also that the pro- ceeds of an unreported borrowing do not qualify for use as a deduction from net transfer of capital under § 313(d) (1) or from positive direct investment under § 306(e), nor can such proceeds be ex- cluded in computing liquid foreign bal- ances for purposes of § 203(c). The prohibitions of § 203(d) (1) apply if available proceeds are held in any form of foreign property, including Canadian foreign balances or other Canadian property, and debt or equity securities of a foreign national (including debt or equity securities of a Canadian person, whether or not such Canadian person is an AFN of the DI) . For purposes of the following exam- ples, assume that DI elects the § 504(a) historical allowable and has historical allowables of $3 million in Schedule A, $2 million in Schedule B and $1 million in Schedule C: Example 18. In June 1970, DI negotiates a long-term foreign borrowing of $10 million. The borrowing is not reported in DI's second quarter report on Form FDI-102 because the proceeds were intended for use in the United States. DI repatriates $8 million to the United States for immediate use and pur- chases 6-month certificates of deposit of a London bank with the remaining $2 million. DI has not made and does not make during 1970 any other long-term foreign borrowings. As of the end of 1970 DI has made a positive net transfer of capital to Schedule A of $2,500,000. The positive net transfer of capi- tal is not prohibited by § 203(d) (1); DI has no available proceeds because the borrowing was not reported as provided in 5 324(c). Note, however, that the 6-month certificates of deposit afe liquid foreign balances, sub- ject to the limitation of § 203(c). Example 19. In March 1970, DI negotiates a long-term foreign borrowing of $10 million, Immediately expends $5 million of the pro- ceeds In a transfer of capital to a Schedule O AFN and purchases 6-month certificates of deposit of a London bank with the remaining $5 million. DI reports the borrowing on Form FDI-102 for the first quarter of 1970 pursuant to § 324(c) . Upon maturity of the certificates of deposit in September, DI withdraws the funds (constituting "available proceeds") and deposits them with a New York bank. During November, DI makes a transfer of capital to Schedule A of $2,500,000, but not with the available proceeds, resulting in a positive net transfer of capital to Schedule A at the end of 1970 of $2,500,000. The posi- tive net transfer of capital to Schedule A is not prohibited by § 203(d) (1) because DI does not hold, as of the end of the year, any available proceeds in the form of foreign property. Example 20. In December 1969, DI nego- tiated a long-term foreign borrowing of $15 million, reported the borrowing as required by § 324(c), and invested $10 million in 13- month certificates of deposit of a London bank. During 1970 DI makes a $2 million pos- itive net transfer of capital to Schedule A and a $1 million positive net transfer of capital to Schedule B. Both positive net transfers of capital are prohibited by § 203(d) (1), since DI had available proceeds held in the form of foreign property on December 31, 1970 (i.e., the 13-month cer- tificates of deposit of the London bank) . Example 21. During 1970, DI negotiates and properly reports a $10 million long-term foreign borrowing and loans the proceeds to a Canadian AFN under a 5-year note. DI also makes a $2 million positive net transfer of capital to Schedule A. Assuming no other transactions, the positive net transfer of capital to Schedule A is prohibited because DI holds available proceeds of long-term foreign borrowing in the form of debt obliga- tions of a foreign person; i,e., the Canadian AFN. (DI could, however, avoid noncompli- ance with § 203(d)(1) by allocating and re- patriating, pursuant to 1306(e), $2 million of the available proceeds to offset the posi- tive direct investment in Schedule A.) Example 22. During 1970, DI's only AFN, a branch in Schedule C, increases net assets by $1 million. By operation of 5 313(b), DI is deemed to have made a $1 million positive net transfer of capital to Schedule C. DI has $2 million of available proceeds of long-term foreign borrowing and such proceeds are in- vested in short-term foreign government se- curities. During the final quarter of 1970 DI allocates $1 million of these proceeds to the positive net transfer of capital to Schedule C, liquidates that amount of foreign securities, repatriates the funds received, and deposits them in a U.S. bank. As of the end of 1970, DI does not have a positive net transfer of capital to Schedule C, and therefore DI is not affected by § 203(d)(1). Note that DI will carry over into 1971 $1 million of available proceeds that are not subject to the repatria- tion requirements of § 203(c) . (ii) Positive net transfer of capital authorized by § 503, § 507 or § 1002. Sec- tion 203(d)(1) does not prohibit a DI holding available proceeds at yearend from making a positive net transfer of capital resulting in positive direct in- vestment if the DI has elected to be governed by § 503 or § 507, nor does that prohibition apply to a positive net trans- fer of capital authorized by § 1002 (re- sulting from the repayment of debt) . Example 23. DI has § 504 allowables for 1969 of $500,000 in Schedule A, $300,000 in Schedule B and $100,000 In Schedule C. Dur- ing 1969, DI negotiates and properly reports a long-term foreign borrowing of $10 mil- lion. DI expends $6 million to acquire a Schedule C AFN and Invests the remaining REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY. OCTOBER 7, 1970 RULES AND REGULATIONS $4 million in 6-month certificates of deposit of a London bank. DI thereafter makes a positive net transfer of capital of $750,000 to Schedule A. DI elects to be governed by the § 503 allowable for 1969. The positive net transfer of capital to Schedule A is not pro- hibited by § 203(d) (1) , even though DI holds available proceeds in the form of foreign balances at the end of 1969. Example 24. During 1967, DI negotiated a long-term foreign borrowing of $15 million and expended all proceeds to acquire a Schedule B AFN. The terms of the borrowing called for repayment of principal in the amount of $2,500,000 in each of 1969, 1970, and 1971, the remainder being due in 1972. DI has a § 504 allowable in Schedule B of $2 million for 1969. During 1969, DI acquires available proceeds from a second long-term foreign borrowing. The proceeds of this bor- rowing are held in a demand account with a foreign bank. During 1969, DI makes the first required repayment of the 1967 borrow- ing as authorized by § 1002(a) (4) , and there are no other relevant transactions during the year. The positive net transfer of capital resulting from the repayment is not pro- hibited by § 203(d) (1). (iii) Positive net transfer of capital prohibited only if positive direct invest- ment results. A DI holding available pro- ceeds in the form of foreign balances or property at yearend is prohibited by § 203(d) (1) from making a positive net transfer of capital to a scheduled area only to the extent such transfer results in positive direct investment. For purposes of the following exam- ples, assume that Dl.has elected a § 504 allowable and that more than $25,000 in available proceeds of long-term for- eign borrowing are held in the form of foreign property. Example 25. DI has five Schedule C APNs, all incorporated, and the AFNs have total losses of $3 million during 1969. During 1969, DI makes a positive net transfer of capital to these Schedule C AFNs of $2,500,000. The positive net transfer of capital is not pro- hibited by § 203(d)(1) because it does not result in positive direct investment. (Section 504(e), which requires total losses in Sched- ule C to be excluded from the calculation of direct investment in Schedule C is not ap- plicable to § 203(d) (1).) The result would be the same if the AFNs and the positive net transfer of capital were in Schedule A or B. Example 26. DI has five Schedule C AFNs, all incorporated, that have aggregate earn- ings of $4 million during 1969, but declare dividends to DI of $5,500,000. During 1969, DI makes a positive net transfer of capital to Schedule C of $1 million. The positive net transfer of capital is not prohibited by § 203 (d) (1), because it does not result in positive direct investment in Schedule C. (iv) Allocation or reallocation to posi- tive direct investment deemed first to reduce positive net transfer of capital. Section 203(d)(1) provides that any allocation to positive direct investment pursuant to § 203(d) (2), § 203(d) (3), or § 306(e) shall be deemed, for purposes of § 203(d) (1), first to reduce the posi- tive net transfer of capital component of positive direct investment. Accordingly, an allocation that serves to offset posi- tive direct investment in a scheduled area for purposes of conforming to a DI's § 504 allowable may also be availed of for purposes of satisfying the require- ment of § 203(d) (1). Example 27. DI elects the 30 percent earn- ings allowable under § 504(b) for 1969, re- sulting in a Schedule B allowable of $2 million. During 1969, DI makes a positive net transfer of capital to Schedule B of $2,500,000 and Its Schedule B AFNs earn $1 million. In addition, DI holds $5 million in available proceeds of long-term foreign borrowing in the form of short-term deposits in a German bank. DI's Schedule B AFNs pay no dividends during 1969. DI must repatriate $1,500,000 of the available proceeds prior to the end of the year and allocate and deduct such amount from positive direct investment pur- suant to § 306(e) to stay within the limits of § 504(b). However, since DI would still hold $3,500,000 of available proceeds in the form of foreign balances, and the net transfer of capital to Schedule B, after taking into ac- count the second proviso to § 203(d)(1), would be $1 million ($2,500,000 less $1,500,- 000 ) , DI is also required to allocate before the end of the year at least an additional $1 million to comply with § 203(d)(1). If this repatriated amount is allocated to posi- tive direct investment under § 306(e) , DI will report on its Form FDI-102F positive direct investment of $1 million in Schedule B dur- ing 1969 (deemed to consist of a zero net transfer of capital plus reinvested earnings of $1 million) and would have a Schedule B carryforward into 1970 of $1 million for its unused allowable in that amount. As. an alternative to allocation, DI may repatriate the remaining $3,500,000 of available proceeds from abroad and hold them in nonforeign assets Section 203(d)(1) would not then apply and DI would show positive direct investment in Schedule B of $2 million, no carryforward of the § 504 allowable and $3,500,000 of available proceeds for use in succeeding years. (v) Application to overseas finance subsidiaries. As provided by § 1403(b) (2) , available overseas proceeds held by an OFS aVe deemed, for purposes of § 203 (d) (1), to be available proceeds of long- term foreign borrowing held by the DI. (vi) Specific exemption from'the pro- hibitions of § 203(d)(1). A DI subject to the prohibitions of § 203(d) (1) may com- ply with the requirements of the section in any of three ways: (a) The DI may expend available proceeds of long-term foreign borrowing in making transfers of capital, so as to avoid having a posi- tive net transfer of capital in any sched- uled area; (b) the DI may allocate avail- able proceeds of long-term foreign borrowing to positive direct investment in each scheduled area, to the extent of a positive net transfer of capital in each scheduled area; or (c) the DI may re- patriate all available proceeds of long- term foreign borrowing to the United States by yearend. Compliance with § 203(d) (1) may, however, be impossible or may result in substantial hardship in certain instances. OFDI will consider applications for specific exemption from § 203(d) (1) upon showing by a DI that compliance with that section cannot be accomplished by any of the means listed above, for one or more of the following reasons : The expenditure of available proceeds in making positive transfers of capital during the year and the liquidation and repatria- tion to the United States of available pro- ceeds would contravene express representa- tions made by the DI to, or restrictions im- posed on the DI by, persons from whom the relevant long-term foreign borrowings were obtained (as conditions to obtaining such borrowings) ; Available proceeds cannot be expended in making positive transfers of capital or re- patriated to the United States, because they were invested in nonliquid long-term foreign investments prior to June 18, 1969; The expenditure of available proceeds in making positive transfers of capital during the year and the liquidation and repatriation to the United States of available proceeds would create a substantial probability of ma- terial adverse United States or foreign tax consequences to the DI (such as jeopardiz- ing the exemption of an international fin- ance subsidiary's interest payments on debt issued to foreign persons from U.S. with- holding tax because of an increase in U.S. source income of the international finance subsidiary) ; or Available proceeds cannot be expended in making positive transfers of capital or re- patriated to the United States without caus- ing demonstrable, material economic hard- ship for the DI (generally, market yield dif- ferentials will not be considered sufficient grounds for such hardship relief). DIs should note Internal Revenue Service Technical Information Release No. 1005, issued December 27, 1968 (Rev. Rul. 69-27), in which there is discussion of several options available under §§ 861- 864 of the Internal Revenue Code (1954) that are consistent with the objectives and requirements of the Foreign Direct Investment Program and will not ad- versely affect an international finance subsidiary's "foreign-source income" position. B304 — Affiliated Foreign Nationals § B304— 1 Introduction. Only persons within the United States who are or who become DIs by virtue of their interests in affiliated foreign na- tionals (AFNs) are subject to the pro- gram. As a general rule, a transaction be- tween a person within the United States and a foreign national (as denned in § 302) that does not affect the U.S. per- son's equity or debt investment in an AFN, or does not result in a foreign na- tional becoming an AFN, is not subject to the direct investment prohibitions im- posed by § 201(a) of the regulations. § B304-2 Summary. Restrictions on foreign direct invest- ment under the program are applicable only to persons within the United States having or acquiring, directly or in- directly, a 10 percent or greater interest in an affiliated foreign national. A "for- eign national" is defined in § 302(a) as — * * * any person which is not a person within the United States * * *, including a corporation or partnership organized under the laws of a foreign country * * *, a busi- ness venture conducted within a foreign country * * *, and a foreign bank * * *. The interest in a foreign national re- quired to make it an AFN for purposes of the regulations is, in general, deter- mined by the U.S. investor's voting rights if the foreign national is a corporation, or by the share of profits to which the investor is entitled if an unincorporated foreign business activity is involved. REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 10 RULES AND REGULATIONS Nonprofit foreign nationals, such as charitable, educational, religious, scien- tific, literary, or. similar organizations, are not treated as AFNs. Business ventures in which an APN has an interest may themselves be AFNs if located in a scheduled area other than that of the parent. Canadian busi- ness ventures of AFNs located in Sched- ule B and non-Canadian, Schedule B business ventures of Canadian AFNs are treated as separate AFNs, even though such relationships within the same scheduled area would ordinarily result in a single AFN. § B304— 3 Requisite financial interest. The interest that will give rise to a DI-AFN relationship is, generally, a 10 percent or greater voting interest in a foreign corporation or a 10 percent or greater interest in the profits of a foreign partnership or business venture. (See §§ 304(b) (2), 901 and 902). However, § 304(b) (4) provides that a DI-AFN re- lationship may be deemed to exist not- withstanding this general Tule. Under present OFDI policy, this caveat applies principally to cases where the U.S. in- vestor actually participates in and exer- cises a controlling interest over the af- fairs of the foreign national, and has transferred funds or other property in excess of $200,000 to the enterprise dur- ing any year commencing with 1968. A relationship which is solely that of debtor and creditor is not subject to the 10-percent interest test (whether or not the loan is secured), even though prin- cipal and/or interest payments by the foreign borrower ma:* result in the U.S. creditor receiving all or a substantial portion of the foreign enterprise's revenues. § B304— 4 Foreign nationals. (i) Corporations. A foreign corpora- tion includes any organization incor- porated under the laws of a foreign country, or having all or a substantial part of the legal characteristics com- monly attributed to corporations under the laws of the United States (§ 307(b) ) . Thus, an organization that is not for- mally incorporated under foreign law but (a) has transferable interests, (b) is organized so that holders of interests are not liable for its obligations except to the extent of their contributions or subscriptions, and (c) has perpetual du- ration (or for a substantial fixed pe- riod), would be considered a foreign corporation. Pursuant to § 304(b)(1), an incorpo- rated AFN is generally assigned to the scheduled area where organized, regard- less of the situs of operations. However, if the AFN conducts no operations in the scheduled area of incorporation but merely maintains a required statutory office there, it may be assigned to a dif- ferent scheduled area for purposes of the regulations (§ 304(b) (4)). (ii) Partnerships. A foreign partner- ship includes formally structured non- corporate organizations created under a partnership law or similar statute of a foreign country. A foreign Joint ven- ture will ordinarily be treated as a "busi- ness venture" (see below) , rather than as a partnership, if it is formed to en- gage in a specific transaction or series of related transactions and is to be liquidated when the transaction or trans- actions have been completed. A foreign partnership is assigned to the scheduled area where it is organized (§ 304(b)(1)). (iii) Business ventures. A foreign busi- ness venture encompasses business ac- tivities in a foreign country (a) by a DI, (b) by employees or partners of a DI on behalf of the DI, or (c) by employees or partners of an AFN on behalf of such AFN (§ 304(a)(1) (ii) and (iii), as lim- ited by § 304 (c) and (d) ) . Some types of facilities abroad, such as storage areas and display offices owned or physically controlled by the DI, may be treated as business ventures for purposes of the regulations even though frequently not considered "permanent establishments" for other legal purposes. The term "employee" as used in § 304 is not necessarily synonymous with its meaning for Federal tax purposes. For example, an agent working substantially full-time for a U.S. principal and having a stock of goods from which orders are filled, or having authority to accept or- ders or otherwise execute contracts on behalf of his principal, may be consid- ered an employee for purposes of this section. Furthermore, the agent's lack of authority to conclude contracts may be immaterial if acceptance by the DI is, in actual practice, merely a ministerial act. Ownership interests in real property abroad (excluding mortgages secured by real property) will constitute business ventures if held primarily for business purposes (including real property held for appreciation). Therefore, crop or grazing acreage, apartment houses and land held for subdivision are considered business ventures. On the othei hand, real property such as a house in a foreign country purchased by a U.S. resident principally for personal use will not be considered held for business purposes even though rented to others for a por- tion of the year. Contract construction, engineering, oil exploration, and similar operations in- volving a jobsite or project office in a foreign country are also business ven- tures. Drilling operations on the U.S. continental shelf or geological drilling in the deep ocean over which no nation asserts jurisdiction are deemed to be conducted within the United States for purposes of the regulations, while drill- ing operations conducted on the conti- nental shelf adjacent to a foreign coun- try are deemed to be conducted in that country. While drilling operations over water are in all other respects treated the same as drilling operations on land, vessels registered in the United States that are used in connection with such operations in the jurisdiction of a for- eign country are assigned a value of zero (and related liabilities or depreciation charges should be excluded) in comput- ing net branch assets of that business venture. Under § 304(a) (1) (ii), a DI's overseas branch is a business venture, whether or not the DI customarily maintains separate books and records reflecting the assets, liabilities, earnings, and expenses, etc. attributable or allocable to the branch. Similarly, a branch of an incor- porated AFN is a foreign business ven- ture, unless located in the same scheduled area as the parent AFN. In such case the parent and its business venture are grouped as a single AFN for purposes of the regulations, provided neither is Ca- nadian (§ 304(a) (1) (i), as qualified by § 304(a)(1) (iii)). If the parent AFN and its business venture are in different scheduled areas, or if in the same sched- uled area and one is Canadian, two AFNs would be attributed to the DI (§ 304 (a) (1) (iii)). Under § 304(b) (1), certain nonperma- nent or transient business ventures con- ducted in more than one scheduled area during any year are assigned to the scheduled area in which the business venture is conducted for the greatest period of time during such year. Thus, for example, a traveling circus perform- ing for short periods of time during a given year in a number of countries in different scheduled areas, but primarily in Schedule C countries, will be treated as a Schedule C AFN for that year. § B304— 5 Specific exceptions. Section 304 (c) and (d) enumerate certain categories of foreign business activities that are not treated as AFNs regardless of the interest that a person within the United States may have or may acquire. Excepted are foreign enter- prises solely of a charitable, educational, religious, scientific, literary, or similar nature not engaged in for profit. Also excepted from treatment as AFNs during a given year are business ventures that (a) do not have or involve, at any time during the year, gross assets of more than $50,000 valued at the greatest of cost, book, replacement, or market (§ 304 (d) (i) ) ; (b) are commenced during the year and are not reasonably expected to be conducted for more than 12 consecu- tive months (§ 304(d) (ii)) ; or (c) are terminated within the year and were not, in fact, conducted for more than 12 consecutive months (§ 304(d) (iii) ) . The test under § 304(d) (i) relates to gross assets determined in accordance with accounting principles generally accepted in the United States. If, at any time during the year, the business ven- ture has gross assets of more than $50,000, it is deemed an AFN for the entire year. The determination whether a business venture in a foreign country is reason- ably expected to be conducted, or is in fact conducted, for a period of 12 con- secutive months, under § 304(d) (ii) and (iii) , is governed by the primary activity of the enterprise during such period. Continuous physical presence is not re- quired. If, for example, a traveling circus spent substantially all of the requisite 12-month period abroad, but returned to the United States occasionally for ap- pearances, the business venture would nevertheless be considered to have been conducted within one or more foreign countries for more than 12 consecutive months. REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 11 With specific reference to contract construction, engineering, and similar operations conducted directly by U.S. companies involving opening of a job site and/or project office in a foreign country (or in waters under the jurisdiction of a foreign country) , the following rules will generally be applied under § 304(d) (ii) and (iii) : The commencement date of the business venture is the date on which the first ma- terials or equipment arrive at the job site, or the date the project office is opened, which- ever is earlier; and The termination date of the business ven- ture is the date when all transfers of capital and earnings attributable to the relevant contract (except for guaranty retentions of a reasonable amount) are charged off the job's books and repatriated to the United States. (Payments under guaranty retentions should be charged off and the balance re- patriated to the United States as soon as practicable.) A determination under § 304(d) (ii) whether an overseas business venture is reasonably expected to be conducted for more than 12 consecutive months should be based on the facts and circumstances existing when the venture is commenced. Determinations need not anticipate de- lays or interruptions that are not fore- seeable when the venture is commenced, such as delays or interruptions due to unanticipated labor strikes or slowdowns or unusual weather conditions. The rule with respect to termination of a business enterprise during any year under § 304(d) (iii) is not intended to be applied inflexibly. If, due to unforeseeable delays or interruptions, a business ven- ture cannot be terminated within the required 12-month period, but is in fact terminated with reasonable dispatch in view of the unanticipated difficulties, a specific exemption from application of the regulations may be granted (see § 801). If an exemption under § 304(d) is applicable to a business venture owned directly by a DI (e.g., a branch of the DI), the venture is not "considered to be an AFN of the DI. Therefore, transfers of capital between the DI and the ven- ture have no effect under the regula- tions, nor do profits (or losses) of the venture. The result is different, how- ever, if an exemption under § 304(d) ap- plies to an AFN's business venture that is located in a different scheduled area from the AFN. Section 304(d) then merely serves to exclude the venture as an AFN of the DI, not to remove it from the reach of the regulations al- together. Ventures of this nature are deemed a part of the parent AFN (as are an AFN's business ventures in the same scheduled area) . Accordingly, profits (or losses) of an incorporated AFN's ven- tures of this nature would be deemed earnings of the parent AFN, transfers of capital to the venture would be deemed transfers to the parent AFN, and any net change in the net assets of the venture would not be reflected in calculating the DI's net transfer of capital to unincorpo- rated AFNs for purposes of § 313(b). § B304-6 Application of § 304. The operation and effect of § 304 are illustrated by the following examples: Example 1. (General.) A U.S. corporation (X) owns 10 percent of the outstanding voting stock of a corporation organized under the laws of France. The foreign company is an incorporated AFN in Schedule C (see §304 (a)(l)(i) and (b)(1)). If the com- pany were incorporated under the laws of Brazil, it would be an incorporated AFN located in Schedule A. If it were incorpo- rated under the laws of the United Kingdom, it would be an incorporated AFN located in Schedule B. If the French AFN has a branch in Italy, or if the AFN in the United Kingdom has a branch in Japan, the branch operations would be subsumed under the parent com- pany for purposes of the regulations, since both parent and branch would be in the same scheduled area (§ 304(a) (1) (i) ) . An ex- ception to this rule applies where either the parent AFN or its branch is located in Can- ada, in which case both would be AFNs (§ 304(a)(1) (iii)). By the same token, if the French corpora- tion has a branch in Germany and a wholly- owned corporate subsidiary in Australia, and the latter has a branch in Canada, DI would have only three AFNs; (a) The French corporate subsidiary, (b) the French corpo- ration's Australian subsidiary, and (c) the latter's Canadian branch. The French AFN's branch in Germany would not be a separate AFN, since Germany and France are in the same scheduled area. The Canadian branch would be a separate AFN since, for purposes of § 304 ( a) ( 1 ) ( iii ) , Canada is not deemed to be a Schedule B country. Example 2. (Voting interest test.) A U.S. corporation owns 95 percent of the outstand- ing voting 6tock of a company in France, the remainder being owned by unaffiliated for- eign nationals. The French company has a 10 percent direct interest in a corporation in Japan. Only the French company is an AFN, since X's indirect interest in the Japanese company is only 9.5 percent, i.e., 95 percent X 10 percent (see §§901, 902). Example 3. (Profit interest test.) An indi- vidual (X) who is a person within the United States is a partner in a partnership (C) organized under the laws of Germany, al- though he is not actively engaged in C's business. Under the partnership agreement, X is entitled to receive 15 percent of the profits of C. C is an unincorporated AFN of X (see §304 (a)(l)(i) and (b)(1)). Example 4. (Indirect profit interest through non-AFN parent.) A French cor- poration (C) has 200,000 shares of stock outstanding, 100,000 of which are voting and 100,000 of which are nonvoting fixed- divided preferred. C has numerous branches in Schedules A and B. For many years, substantially all of C's profits (including branch profits) have been distributed as dividends to holders of the preferred stock and no dividends have been paid on the common stock. A corporation in the United States (X) owns 8,000 shares of C's voting stock (8 p rcent) and 70,000 shares of the preferred stock (70 percent); however, this investment has not been accompanied by active participation in or control over C's business affairs. C is not an AFN of X. More- over, although X has for many years re- ceived more than 10 percent of the profits of C's Schedule A and B branches, in the form of preferred stock dividends from C, OFDI would not consider the branches to be AFNs. A foreign business venture owned directly by a foreign corporation or partner- ship is not treated as an AFN of a U.S. person unless the parent is also an AFN of the U.S. person. Example 5. (Exception to the 10 percent interest test.) A U.S. corporation (X) owns 9 percent of the outstanding voting stock of a French corporation (C). X also owns a current option to acquire additional voting stock of C that, if exercised, would give X ownership of 35 percent of C's outstanding voting stock. Moreover, a majority of C's directors are designees of X and, for a num- ber of years, X has actively participated in and exercised a controlling influence over the affairs of C. Under § 304(b) (4), OFDI could deem C to be an AFN notwithstanding X's present 9 percent interest. As a matter of policy, however, such discretion would not normally be exercised unless X transfers more than $200,000 in funds or other prop- erty to C during any year commencing with the year 1968. Example 6. (Second-tier AFNs.) A U.S. cor- poration (X) owns 10 percent of the out- standing voting stock of a French corporation (C). C owns a factory in Argentina, a sales office in Brazil, a sales office in Japan, a sales office in the United Kingdom and numerous factories and sales offices in continental Eu- rope. The Japanese sales office has gross as- sets of less than $50,000 and, therefore, can- not be .an AFN because of the exemption in § 304(d) (i). Accordingly, C is an incorpo- rated AFN located in Schedule C, embracing also the factories and sales offices in conti- nental Europe and in Japan. Assuming the inapplicability of the exemptions set forth in § 304(d), the factory in Argentina, the sales office in Brazil, and the sales office in the United Kingdom are separate unincor- ported AFNs of X (§304 (a)(1) (iii) and (b) (1)). Example 7. (Bank or brokerage account.) An individual within the United States main- tains a number of bank accounts with foreign banks and also maintains an account with a German stock brokerage firm. Neither the bank accounts nor the brokerage account are AFNs. Example 8. (Investment real estate.) An individual within the United States pur- chased a parcel of 1,000 acres of undeveloped real estate in Brazil for $75,000 in 1967. The land is being held for investment. The real estate is an unincorporated AFN (see § 304 (a)(1) (ii) and (b)(1). Example 9. (Commission salesmen.) A U.S. corporation (X) enters into a contract with an individual citizen of Argentina (A) pursuant to which A will be X's exclusive representative in Latin America to solicit orders for X's products. A is not to handle the products of any other company but is to work full time in soliciting orders for X. A has no authority to accept orders, but must forward them to X for approval. A is to be compensated on a commission basis based on the gross sales of X's products attributable to A's efforts. All payments for such sales must be remitted directly to X by the pur- chaser. X is to pay the rental for A's office in Buenos Aires, but all of A's other expenses (including the salaries of clerical and other required personnel) are to be paid by A out of his commissions. The Buenos Aires tele- phone directly is to carry a listing in X's name showing the telephone number of A's office. X also rents space in a warehouse in Buenos Aires, from which orders from Latin American customers are filled. Under the foregoing facts A's operation is not an AFN. Example 10. (Sales agents.) A U.S. corpo- ration (X) employs five salesmen who travel throughout Europe to solicit orders for X's products. The salesmen operate out of a rented office in France and are all permanent residents of France. All orders must be ac- cepted by X in the United States, but pay- ment is made to the office in France. The rental and all other expenses of the sales of- fice, including the salaries of the salesmen and other office personnel, are paid by X. As- suming the inapplicability of § 304(d), the sales office operation is an unincorporated AFN of X because it is a business venture conducted on behalf of X by employees of X (see §304 (a)(1)(h) and (b)(1)). Example 11. (Sales agents; leased ware- house facilities.) A U.S. corporation (X) sells REPRINTED FROM FEDERAL REGISTER, VOL. 35. NO. 195— WEDNESDAY, OCTOBER 7, 1970 12 RULES AND REGULATIONS Its products in continental Europe through independent sales agents in Europe, who also sell products of many other U.S. corpora- tions. The agents are compensated strictly on a commission based on their gross sales of X's products. X also employs salaried sales- men in the United States who periodically travel to Europe to make sales to X's largest European customers. X does not maintain any permanent manufacturing or sales fa- cility in Europe. Under the foregoing facts X does not have AFNs in Schedule C. In addition, if In order to expedite deliveries to its European customers, X rents space in a warehouse in the Netherlands where a sub- stantial inventory is maintained and orders from X's European customers are filled from this Inventory, periodically being replen- ished by X, such operation would not con- stitute an AFN. Note that the result would be different if X owned the warehouse (as- suming the inapplicability of § 304(d)); in that case, the warehouse itself would be an AFN. Example 12. (U.S. -based consulting serv- ices.) A U.S. corporation (X) is engaged in rendering management consulting services. Many of its clients are unaffiliated foreign corporations. During the course of a year, X's salaried personnel, all of whom are perma- nent residents of the United States, travel to X's foreign customers to render consulting services. They typically work at the head of- fices of the foreign companies for 1 to 2 months at a time. X does not have any AFNs by virtue of the foregoing facts. Example 13. (Construction projects.) AUS. corporation (X) is engaged in the construc- tion business. During the course of a year, X bids on numerous European construction projects and receives contracts on a small fraction thereof. X has a permanent office in France where a variety of personnel are em- ployed, principally to gather information concerning contemplated construction proj- ects and to supervise and coordinate all proj- ects on which X is then working. In January 1968, X received two contracts for construc- tion of factories in Germany and Belgium. Soon thereafter, X transferred men and equipment to the project sites. Assuming the inapplicability of 1304(d), each project site is an unincorporated AFN of X, as is X's office in France (see § 304 (a)(1) (ill) and (b)(1)). (Note that the office in France is an AFN without regard to the opening of the German and Belgian project sites.) Example 14. (Oil concessions and licenses for exploration.) A U.S. corporation (X) ob- tains a concession from a Schedule B country to drill for oil within that country. X then enters into a Joint venture agreement with two U.S. and two foreign companies for the purpose of exploiting the concession. Under the terms of the agreement, X is entitled to receive 25 percent of any ensuing production. The oil exploration venture is an unincorpo- rated AFN of X located in Schedule B (see § 304 (a) (1) (11) and (b) ( 1 )). Note that the joint venture will also be an unicorporated AFN of the other U.S. corporations, and that X and the other U.S. corporations are mem- bers of an "associated group". (See § 905.) Example 15. (Retail franchises.) A U.S. corporation (X) operates, under a 6lngle trade name, a chain of quick-service rest- aurants throughout the United States. "X franchises an unaffilated French corporation (C) to open a restaurant in France using X's trade name. C agrees to purchase some of its goods from X, maintain certain quality standards, and pay X a yearly royalty based on profits. X does not have an AFN In France by virtue of this franchise arrangement. Example 16. (Break-even or loss ventures.) Four U.S. news-publishing corporations (V, W, X, and Y) establish a membership corpo- ration under New York law (Z). V, W, X, and Y each contributes 25 percent of the capital required by Z and each has 25 per- cent of the voting power in Z. Z Is to gather news for the respective publications of V, W, X, and Y. In this connection, Z will estab- lish and staff various permanent news- gathering offices throughout the world. Z is designed to operate on a break-even basis. The offices established by Z are unincorpo- rated AFNs of V, W, X, Y, and Z even though not themselves operated for profit, since they are directly related to business activities that are for profit. B305 — Direct Investor Section 305 defines the term "direct investor" ("DI") generally to mean any person within the United States (defined in § 322) owning or acquiring (directly or indirectly) a 10 percent or greater in- terest in a corporation or partnership organized under the laws of a foreign country or in a business venture con- ducted within a foreign country (an "affiliated foreign national," defined in § 304). A DI may be a multiple entity or sev- eral individuals treated as a single per- son under § 323 (international finance subsidiaries of a direct investor) . § 903 (affiliated groups) , or § 904 (family groups) . The term also includes a person owning less than a 10 percent interest in a particular foreign corporation, part- nership or business venture, if (a) such person is a member of an associated group, as defined in § 905, that acts in concert pursuant to an agreement or understanding to own or to acquire a 10 percent interest in the foreign enterprise, or (b) such person owns a direct inter- est in another DI and an election, con- sented to by such person, is made with respect to such other DI under § 906 (b)(1). A person within the United States first acquiring the requisite interest in a for- eign corporation, partnership, or busi- ness venture will be treated as having been a DI in the foreign enterprise immediately preceding the acquisition. Accordingly, initial acquisition of the requisite interest will involve a § 312(a) (1) transfer of capital (see also § 313(d) (2) ) . Thus, for example, if a U.S. corpo- ration (X) , owning no interest in a French corporation (C) , acquires 10 per- cent or more of the outstanding voting stock of C from an unaffiliated foreign national for $1 million in cash, X will be treated as a DI in C immediately prior to the closing of such acquisition and will, therefore, be treated as having made a $1 million transfer of capital to C. Although acquisition or ownership of a 10 percent voting interest in a foreign corporation, or a 10 percent profits inter- est in a foreign partnership or business venture, is ordinarily required, to consti- tute the foreign enterprise an AFN of a person within the United States, the regulations provide that a foreign en- terprise in which a lesser interest is held may nevertheless be deemed an AFN (§ 304(b)(4)). For example, such dis- cretionary authority might be exercised if a U.S. person were to acquire a contin- gent 10 percent interest in the voting securities of a foreign corporation, or a 10 percent present interest in the capital or earnings of a foreign corporation without voting rights. As a general rule, however, such determination would not be made by OFDI unless the U.S. person actually participates in and exercises a controlling influence over the affairs of the foreign enterprise and transfers funds or other property to the foreign enterprise exceeding $200,000 during any year commencing with 1968. B306 — Direct Investment § 1)306—1 Introduction. Section 306(a) defines the term "di- rect investment" for purposes of the reg- ulations. Direct investment, which may be positive or negative, means the sum of a DI's net transfer of capital to in- corporated and unincorporated AFNs (defined in § 313(c) ) and the DI's share of reinvested earnings of incorporated AFNs (defined in § 306(b)) during any period, usually a calendar year (see § 321) . A DI governed by the § 503 mini- mum allowable will calculate direct in- vestment on a worldwide basis. A DI governed by the § 504(a) historical al- lowable or the § 504(b) earnings allow- able will calculate direct investment on a schedular basis. A DI governed by the § 507 alternative minimum and Shedule A supplemental allowable will calculate direct investment on a combined basis for Schedules B and C and separately for Schedule A. Under § 313(d)(1), proceeds of long- term foreign borrowing (defined in § 324 (c) ) actually expended by a DI in mak- ing transfers of capital to AFNs are de- ducted in calculating the net transfer of capital component of direct investment. Section 306(e)(1) permits deduction of "available proceeds" of such borrowing (defined in § 324(d)) that are "allo- cated" on the DI's books and records as an offset to positive direct investment. § B306— 2 Summary. In addition to defining the term "di- rect investment," § 306 deals with calcu- lation of "reinvested earnings" and sets forth a number of rules to be followed in calculating the DI's share of such earnings as a component of direct investment. The major topics covered in §306 are: Basic definition of direct investment (§ 306(a) ) ; definition of reinvested earn- ings (§ 306(b)); calculation of AFN earnings or losses (§ 306(c)); branch AFN earnings deemed remitted (§ 306(d) (1) ) ; definitions and rules for dividends (§ 306(d) (2) ) , and allocation of proceeds of long-term foreign borrowing (§ 306 (e)>. § B306— 3 Relation of § Suo to other sections. Direct investment as denned in § 306 consists of a number of components. The way In which these various components enter into the calculation of direct in- vestment is illustrated by the following diagram: REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 13 NET TRANSFER OF CAPITAL (} 313) Component* +Transfers of capital: DI to AFNs (§ 312(a)). —Transfers of capital: AFNs to DI (§312(b)). —Expended proceeds of long-term foreign borrowing (§ 313(d)(1)). zfcTransfers of capital: AFNs to AFNs (§505). ±Net transfer of capital: DI to un- incorporated AFN, i.e., net increase or decrease in assets (§ 313(b)). Computation or Direct Investment REINVESTED EARNINGS (§ 305(b)) PUt Comptmentt DI's share of: -(-Total earnings (§ 306(c)). -Dividends to DI (1 306(b) (2)(x)). — Dividends paid by AFNs to AFNs in other areas (§ 306(b) (2)(y)). + Dividends received by AFNs from AFNs in other areas (§306 (b)(l)(i)). -(-Profits remitted from unincor- porated AFNs in other areas (§306 (b)(1)(h)). less Allocated Proceeds of Long-Term Foreign Borrowing (§§ 306(e), 203(d)(2) and (3).) § B306-4 Application of § 306. The § 306(a) definition of direct in- vestment applies to calculations in all scheduled areas during 1965-6G as well as for subsequent years. The rules for calculating direct invest- ment are modified in § 504(e) . A DI gov- erned by one of the § 504 allowables is required to disregard total losses of Schedule C incorporated AFNs in cal- culating direct investment in that sched- uled area. Note that in 1969, if the AFNs of a DI governed by the § 503 minimum allowable had an aggregate annual loss, the DI was required to disregard such aggregate annual loss in calculating di- rect investment. See former § 503(b), which has been revoked for 1970 and succeeding years. § B306— 5 Basic definition and calcula- tion of direct investment. Section 306(a) defines direct invest- ment during any period as the sum of (a) net transfer of capital (defined in § 313(c)) and (b) the DI's share in the reinvested earnings of all incorporated AFNs (defined in § 306(b)). If the sum of DI's net transfer of capital and DI's share of reinvested earnings is greater than zero, DI has made "positive direct investment"; if the sum is less than zero, DI has" made "negative direct invest- ment." Direct investment is an aggregate con- cept. It does not refer to individual trans- actions, but to the net effect of all transactions during a reporting period. Direct investment is also a schedular concept. It does not apply to individual AFNs or countries, but to all AFNs of a DI located in each scheduled area. Since § 503 provides a worldwide allowable, however, a DI governed by this section will report direct investment on a con- solidated, worldwide basis, and a DI gov- erned by § 507 will report direct investment in Schedules B and C on a consolidated basis. Direct investment in Canada is ex- cluded from the computation of direct investment under § 306(a) . (See §§ 1103- 1104.) The following examples illustrate cal- culation of direct investment under § 306(a) : Example 1. DI has several wholly owned Incorporated AFNs in Schedule A. (The num- ber of individual AFNs Is not important.) DI has no other AFNs. During 1969 the AFNs together earn $800,000 and pay dividends of $200,000 to DI. DI's share in reinvested earnings, therefore, is $600,000. DI also makes a § 313(a) net transfer of capital to the AFNs of $500,000. DI has made positive direct In- vestment in Schedule A for 1969 of $1,100,- 000. In 1970 the same AFNs earn $600,000 and pay no dividends. During that year, however, the AFNs jointly loaned DI $700,000, result- ing in a negative net transfer of capital In that amount, by operation of §§ 312(b) (1) and 313(a). Accordingly, DI has made nega- tive direct investment of $100,000. Example 2. DI's only AFNs are two wholly owned incorporated AFNs in Schedule B: X and Y. During 1969 X earns $400,000, and Y has losses of $200,000. No dividends are paid, and DI makes no net transfer of capital. DI's share of reinvested earnings is $200,000. Positive direct investment for 1969 is also $200,000, since the net transfer of capital was zero. During 1970, X has earnings of $100,000, and Y has losses of $300,000. X pays DI a dividend of $50,000. Reinvested earnings are negative in the amount of $250,000 (total losses and dividends). DI's net transfer of capital to Schedule B under § 313(a) Is $600,000. Positive direct investment for 1970 is, therefore, $350,000 ($600,000 positive net transfer of capital less the $250,000 negative reinvested earnings). If X and Y had been located in Schedule C and DI had elected a § 504 allowable, § 504 (e) would have required the total losses of $200,000 to be omitted from calculation of direct investment. Direct investment would then have been $550,000. Example 3. DI has a group of wholly owned incorporated AFNs in Schedule C that have subsidiaries (also AFNs of the DI) in Sched- ules A and B. In 1969 the Schedule C AFNs have earnings of zero and pay no dividends. DI makes no transfers of capital. However, the Schedule C AFNs receive dividends of $300,000 from their subsidiaries in Schedules A and B. As a result, DI has made positive direct investment of $300,000 in Schedule C consisting entirely of reinvested earnings. (Reinvested earnings in a given scheduled area are increased by dividends received by AFNs from AFNs in other scheduled areas, and reinvested earnings are reduced in the scheduled area from which the dividends are paid (see § 306(b).) § B306— 6 Reinvested earnings of incor- porated AFNs. To compute a DI's share in the rein- vested earnings of all incorporated AFNs in a scheduled area during any year, it is first necessary to determine the DI's share of the total earnings (or total losses) of such AFNs during the year, as defined in § 306(c). Total earnings or losses consist of the aggregate earnings or losses of each of the incorporated AFNs in a particular scheduled area. Reinvested earnings are then found by adjusting total earnings to take into account dividends to the DI and inter- schedular dividends and profit remit- tances. (i) Total earnings. Earnings or losses of each incorporated AFN should be computed in accordance with accounting principles (including principles of con- solidation) generally accepted in the United States and consistently applied by the DI in financial reports for presenta- tion to stockholders. Any material change in accounting procedures fol- lowed by a DI should be disclosed on the reporting form filed with OFDI for the period in which the change was made, together with an indication of the effects of such change. In calculating total earnings of in- corporated AFNs, the following con- siderations merit particular attention: Dividends: Dividends received by an incor- porated AFN from another incorporated AFN, whether In the same or another scheduled area, should not be Included In calculating earnings of the recipient AFN. (See § 306(c) .) Profit interest in unincorporated AFN of the DI: If an Incorporated AFN has an inter- est in a partnership or business venture in another scheduled area that is a separate un- incorporated AFN under § 304, the incorpo- rated AFN's share in any profits of the unin- corporated AFN should not be included in calculating earnings of the incorporated AFN, whether or not any such profits are actually remitted. (See § 306 (c) and (d) (DO Interests in United States: If an incorpo- rated AFN has an interest in a U.S. corpora- tion, partnership or business venture that would be a separate AFN of the DI if such U.S. enterprise were a foreign national, neither dividends received from such corpo- ration nor the share in profits of such part- nership or business venture (whether or not any such profits are actually remitted) should be included In calculating earnings of the incorporated AFN. Foreign taxes: Earnings of Incorporated AFNs should be computed net of foreign taxes on income or net worth. Foreign with- holding taxes on dividends paid or branch profits distributed should not, however, be deducted except for withholding taxes on dividends received by an incorporated AFN from AFNs in the same scheduled area. (See 5 306(c).) Charge for intangibles: No deduction for amortization or any like charge against earn- ings should be made with respect to an in- tangible owned by an AFN, if transfer of the intangible by the DI to the AFN was made on or after January 1, 1968, and was not con- sidered a transfer of capital by virtue of §312(c)(ll). Blocked earnings: Earnings that are "blocked" because of exchange controls or other like restrictions imposed by the gov- ernment of a foreign country should never- theless be included in earnings. Under cer- tain conditions, OFDI may grant appropriate relief (pursuant to § 801) in these circum- stances. (See Appendix hereto.) Reserve requirements: No deductions from earnings should be made because of reserves for reinvestment, asset revaluation or legal reserve requirements, whether or not locally required, if they would not be proper charges to income under generally accepted U.S. ac- counting principles consistently applied. Valuation: The assets, liabilities, and earn- ings of an AFN expressed In foreign currency should be converted into U.S. dollar equiva- lents in accordance with generally accepted U.S. accounting principles consistently ap- plied. Such accounting treatment should also be followed with respect to gain or loss re- sulting from currency devaluation or revalu- ation. Extraordinary gains and losses: Extraordi- nary gains and losses of an incorporated AFN (including gains or losses resulting from sales REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 14 RULES AND REGULATIONS by the APN of interests in other AFNs), casualty insurance proceeds to the extent that they exceed the value of the assets lost or damaged and proceeds of business inter- ruption insurance should generally be in- cluded in earnings. However, gains or losses realized by a DI resulting from sale of an interest in an AFN are not included in rein- vested earnings under § 306(b) in any sched- uled area; rather, they constitute a transfer of capital to the DI under § 312(b) (5). The following example illustrates cal- culation of total earnings of incorporated AFNs in a given scheduled area, pursuant to§ 306(c) : Example 4. DI has three wholly owned sub- sidiaries in Schedule C. One subsidiary (D) has a branch (W) in Schedule A and a branch (X) in Schedule C; W is a separate APN of the DI, but X is not. (See § 304(a) (1) (iii).) Another subsidiary (E) has a wholly owned subsidiary (Y) in Schedule B and an- other wholly owned subsidiary (Z) in Sched- ule C. The third subsidiary (P) has no branches or subsidiaries. The following occurs during 1969: D earns $1,700,000, $200,000 of which is attributable to earnings of W and $500,000 to earnings of X. Y earns $500,000 and pays a dividend of $300,000 to E. Z earns $200,000, a portion of which is attributable to sale of merchandise to D, and pays a dividend of $100,000 to E. E earns $2,400,000, including the dividends from Y and Z. F incurs a loss of $400,000. Under § 306(c), total earnings of DI's in- corporated Schedule C APNs (D, E, and P) are $3,300,000, computed as follows (000 omitted) : Earnings of D under § 306(c) (W's earnings of $200 are excluded, since W is in another scheduled area. X's earnings of $500 are not excluded, because X is not a sep- rate APN) $1, 500 Earnings of E underj 306(c) (Divi- dends of $300 from Y and $100 Prom Z are excluded) 2,000 Earnings of Z under § 306(c) (Por- tion attributable to sales to D included) 200 Loss of F (400) Total earnings 3,300 (ii) DI's share of total earnings. A DI's share in the total earnings (or losses) of incorporated AFNs in a given sched- uled area is the sum of the DI's percent- age interest in total earnings (or losses) of each such AFN in that scheduled area. Example 5. DI has three incorporated APNs in Schedule C (companies D, E, and F) . DI owns 50 percent of the stock of D, 60 per- cent of the stock of E and 80 percent of the stock of F. D has a branch (W) in Schedule A and a branch (X) in Schedule C; W is a separate AFN of DI, but X Is not. (See § 304(a) (1) (iii).) E has a wholly owned sub- sidiary (Y) in Schedule B and another wholly owned subsidiary (Z) in Schedule C. The following occurs during 1969: D earns $1,700,000, $200,000 of which is attributable to earnings of W and $500,000 to earnings of X. Y earns $500,000 and pays a dividend of $300,000 to E. Z earns $200,000, a portion of which is attributable to sale of mer- chandise to D, and pays a dividend of $100,000 to E. E earns $2,400,000 including the dividends from Y and Z. F incurs a loss of $400,000. DI's share in the total earnings of incor- porated Schedule C AFNs Is $1,750,000 com- puted as follows, pursuant to § 306(c) (see table in Example 4 for treatment of earnings of the AFNs' branches or subsidiaries) : AFN earnings DI's share (000 omitted) (000 omitted) Earnings of D ($1,500X50%) $750 Earnings of E ($2,000x60%) 1,200 Earnings of Z ($200X60%) 120 Loss of F ($400X80%) (320) DI's share of total earnings 1,750 It should be stressed that in Examples 4 and 5 above, only earnings of DI's Schedule C incorporated AFNs were the subject of consideration. Y's earnings would be included in the calculation of reinvested earnings for DI's Schedule B incorporated AFNs under § 306(b), and the profits of W would be included in DI's net transfer of capital to unincor- porated AFNs in Schedule A under § 313(b). Total earnings should always be care- fully distinguished fronrreinvested earn- ings and from earnings of unincorpo- rated AFNs. (iii) Reinvested earnings. After com- puting total earnings of incorporated AFNs and DI's share thereof, the next step in calculating direct investment is to find the DI's share of reinvested earn- ings. The method of determining re- invested earnings of incorporated AFNs in any scheduled area during a year is set forth in § 306(b). The DI's share of reinvested earnings in a scheduled area will generally equal the DI's share of total earnings of such AFNs for the year, less all dividends paid during the year by the AFNs to the DI and to AFNs in other scheduled areas, plus dividends re- ceived from incorporated AFNs in other scheduled areas and profits remitted from unincorporated AFNs in other scheduled areas. Under § 306(d) (1) , profits of an unin- corporated AFN during the year are deemed to have been remitted to the ex- tent that profits exceed the net increase in the net assets of such AFN during the year; if there has been no change, or a decrease, in such net assets during the year, all profits for such year are deemed to have been remitted. Dividends paid by incorporated AFNs to the DI or other AFNs are reported before deduction of foreign dividend withholding taxes; divi- dends and other profit distributions re- ceived by AFNs from AFNs in other scheduled areas are reported after de- duction of foreign dividend withholding taxes. For purposes of the regulations, divi- dends include all cash dividends, whether paid out of current or accumulated earnings. Stock dividends or dividends in kind do not qualify as dividends under the regulations. (See § 306(d) (2).) Dis- tributions in complete or partial liquida- tion will qualify as dividends, but only to the extent the corporation being liqui- dated has current or accumulated earn- ings properly allocable to the distribu- tions. Payments to a DI of amounts previously taxed under the provisions of §§ 551 through 558 and 951 through 981 of the Internal Revenue Code (1954) will qualify as dividends. Dividends paid by one AFN to another AFN in the same scheduled area do not enter into any of the calculations re- quired by § 306. They are not included in determining earnings of the recipient AFN, they are not deducted in calculating total dividends paid by the recipient AFN, and they are not included as divi- dends in calculating total dividends paid by the paying AFN. However, any foreign withholding taxes imposed on the pay- ment of such dividends should be de- ducted in calculating total earnings of incorporated AFNs in the scheduled area involved. For example, DI has a wholly owned subsidiary (X) in Schedule C, that in turn has a wholly owned subsidiary (Y) in Schedule C. X and Y each earn $100,000, Y pays a $50,000 dividend to X on which there is imposed a $15,000 for- eign withholding tax.^uid X pays a $50,000 dividend to DI on which there is also imposed a foreign withholding tax of $10,000. Total earnings of DI's Schedule C incorporated AFNs are $185,000 (i.e., $200,000 minus the $15,000 tax on divi- dend from Y to X) and DI's share in reinvested earnings of all such AFNs is $135,000 (i.e., $185,000 minus the $50,000 dividend (excluding the $10,000 tax) paid by X to DI) . A dividend will generally be considered as having been paid or received when it first becomes payable on demand. This will ordinarily coincide with the dividend payment date, but in some cases it may coincide with the declaration date. Note that a dividend declared but not paid by an AFN when due is treated as having been paid (thus reducing the DI's share in reinvested earnings of the AFN) and then loaned back to the AFN (resulting in a transfer of capital by the DI to the AFN) ; subsequent payment of the amount due by the AFN will then be treated as a transfer of capital by the AFN to the DI. The same attribution of transfers of capital is applicable to divi- dends declared by an AFN that are not paid when due to AFNs in another sched- uled area. It should be noted that a DI may elect, on its original Base Period Report (Form FDI-101), to treat dividends received from AFNs within 60 days after the end of any compliance year as having been paid during such year; such election, if made, must also be reflected in the cal- culation of direct investment during the base period years, and cannot be changed without the permission of OFDI. The following formula may be helpful in applying the § 306(b) definition of reinvested earnings: RE = TE— [(DP + dp) — (dr + pr) ] RE = DI's share of reinvested earnings of all incorporated AFNs in a sched- uled area. TE = DI's share of total earnings of all incorporated AFNs in the scheduled area. DP=Dividends declared by AFNs in the scheduled area that are paid or payable to DI. dp = DI's share of dividends declared by AFNs in the scheduled area that are paid or payable to AFNs in other areas. dr=DI's share of dividends that are paid or payable to AFNs in the sched- uled area by AFNs in other areas. pr=DI's share of profits remitted to AFNs in the scheduled area from unin- corporated AFNs in other areas. REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY. OCTOBER 7, 1970 RULES AND REGULATIONS 15 Example 6. DI has two wholly owned and two 60-percent-owned subsidiaries In Sched- ule C. One wholly owned subsidiary (D) has a branch (V) in Schedule A. The second wholly owned subsidiary (E) has a 50-per- cent-owned subsidiary (W) In Schedule A. One 60-percent-owned subsidiary (F) has a branch (X) in Schedule A. The branches V and X in Schedule A are separate APNs. See § 304(a) (1) (iil). The other 60-percent- owned subsidiary (G) has a wholly owned subsidiary (Z) in Schedule A. DI also has a wholly owned subsidiary (H) in Schedule A. In 1969 D earns $800,000 and pays a divi- dend of $500,000 to DI. Of D's earnings, $300,000 is attributable to profits of V, which had an increase in net assets of $100,000. E earns $500,000 and pays no dividends to DI. Of E's earnings, $200,000 is attributable to a dividend received from W, which Itself earns $600,000. F earns $1 million and pays a divi- dend of $200,000 to DI. Of F's earnings, $200,- 000 is attributable to profits of X, which had no change in its net assets. G earns $2 mil- lion and pays a dividend of $500,000 to DI. Of G's earnings, $400,000 is attributable to a dividend received from Z, which itself earns $900,000. H earns $1,500,000 and pays a divi- dend of $1 million to DI. Reinvested earn- ings of DI's Incorporated AFNs are computed as follows: Schedule C reinvested earnings [RE] : DI's share in the total reinvested earnings of its incorporated Schedule C AFNs (D, E, F, and G) is $1,800,000 computed as follows (000 omitted) : Total earnings [TE] : DI's share of earnings of D : $800 less profits of V ($300) $500 DI's share of earnings of E: $500 less dividend received from W ($200) ._ 300 DI's share of earnings of F : $600 less profits of X ($200x60%) 460 DI's share of earnings of G: $1,200 less dividend received from Z ($400X60%) 960 DI's share of total earnings 2, 240 Dividends paid to DI [DP] : By D $500 By E By F 200 By G 500 Total 1 1,200 Dividends paid to AFNs in other areas [dp] $0 Dividends received and profits remit- ted [dr + pr] : DI's share of profits deemed remit- ted by V to D under § 306(d) (1) : Earnings ($300) less net increase in assets ($100) 200 DI's share of dividends received by E from W 200 DI's share of profits deemed remit- ted by X to F under § 306(d)(1) ($200X60%) 120 DI's share of dividend received by G from Z ($400X60%) 240 DI's share of all dividends received and profits remitted 760 Applying the formula RE = TE — [(DP + dp)- (dr + pr)]: RE = $2,240- [ $1, 200 — $'J60] = $1,800 Schedule A reinvested earnings [RE] : DI's share in the total reinvested earnings of its incorporated Schedule A AFNs (H, W, and Z) is $900,000 computed as follows (000 omitted) : Total earnings [TE] : DI's share of earnings of H $1,500 DI's share of earnings of W ($600 X 50 percent) 300 DI's share of earnings of Z ($900 X 60 percent) 540 DI's share of total earnings 2,340 Dividends paid to DI and DI's share of dividends paid to AFNs in other areas [DP + dp] : Dividends paid by H to DI $1,000 DI's share of dividend paid by W to E 200 DI's share of dividend paid by Z to G ($400X60 percent) 240 Total 1,440 Dividends received and profits remit- ted [dr + pr] Applying the formula RE = TE— [(DP + dp)- (dr+pr)]: RE = $2,340- [$1,440-0] =$900 Example 7. Assume the same facts as in Example 6 above, except that H incurs a loss of $1 million and pays no dividend. DI's share in the total reinvested earnings of Schedule A AFNs is a negative $600,000, com- puted as follows (000 omitted) : Total earnings [TE] : DI's share of loss of H ($1, 000) DI's share of earnings of W 300 DI's share of earnings of Z 540 DI's share of total earnings (160) DI's share of dividends paid [dp] : W to E $200 Z to G 240 Total 440 RE = TE- [(DP + dp) -(dr + pr) ] RE=-$160-[(0 + $440) -0] = -$600 § B306— 7 Deduction from positive di- rect investment: Allocated proceeds of long-term foreign borrowing. Under § 306(e) , the amount of positive direct investment charged to a DI may be reduced by allocating available pro- ceeds of long-term foreign borrowing (see § 324(d) ) . Positive direct investment may also be reduced by allocating pro- ceeds of long-term foreign borrowing that were previously expended in making a transfer of capital to another scheduled area (see § 203(d) (2) ), and by reallocat- ing proceeds previously allocated to a transfer of capital or positive direct in- vestment in another scheduled area (see § 203(d)(3)). An allocation of available proceeds to reduce positive direct investment is sub- ject to certain conditions: The allocation must be reflected on the books and records required to be maintained by the DI under §§ 203(b) and 601. The allocation and reduction of positive direct investment must be reported on the DI's Form FDI-102F covering the year in which the reduction is made. At the end of a year in which an alloca- tion is made, proceeds that were allocated may not be held, directly or indirectly, in the form of foreign balances (see § 203(a)(1)), securities of foreign nationals, or any other foreign property. In succeeding years, allocated proceeds may not be held in the form of foreign property, except that such proceeds may be expended In making transfers of capital to AFNs. Such an expenditure will not be eligible for the deduction from net transfer of capital pro- vided under § 313(d)(1). The concept of allocation is illustrated in the following example: Example 8. In 1969 DI makes a net transrer of capital to its AFNs in Schedule A in the amount of $800,000, and its share of rein- vested earnings of incorporated AFNs in Schedule A is $500,000. DI has made positive direct investment under § 306(a) of $1,300.- 000. If DI has available proceeds in the amount of $1,300,000 at the end of 1969. and the proceeds are not then held in the form of foreign property, DI may allocate such proceeds to its positive direct investment in Schedule A and reduce the amount of such Investment to zero. The allocation and re- duction must be reflected on DI's books and records and on Form FDI-102F for the year 1969. In addition to § 306(e), three other provisions of the regulations relate to de- ductions for use of proceeds of long-term foreign borrowing. Section 313(d)(1) provides for mandatory deduction from net transfer of capital of the amount of proceeds (defined in § 324(c)) actually expended in making transfers of capital. Section 203(d) (2) and (3) are analogous to § 306(e) insofar as they allow deduc- tions from positive direct investment for allocation of proceeds. Section 203(d) (2) allows a DI to allocate previously ex- pended proceeds (or proceeds allocated during 1968) to a new scheduled area, thus obtaining a deduction from positive direct investment in the new area (with a corresponding § 312(a) transfer of capital to the prior area) . Section 203(d) (3) allows a DI to reallocate to a new scheduled area proceeds previously allo- cated under § 306(e) (with a correspond- ing § 312(a) transfer of capital to the prior area) . For a more detailed analysis of long- term foreign boi-rowing, see § B324. Section 306(e) (3) provides for the schedular apportionment of deductions for allocations of borrowings to positive direct investment calculated on a world- wide basis under § 503 or calculated on a combined schedular basis under § 507 as to Schedules B and C. Section 306(e) (3) is applicable only if the DI elects a schedular aDowable and in the same year incurs a repayment charge or makes a reallocation with respect to a borrowing previously allocated to worldwide or combined schedular investment under § 503 or § 507. For example, if the DI takes a § 306(e) deduction from world- wide positive direct investment under § 503 and then repays the borrowing in a year in which § 504 or § 507 is elected, the repayment charge to each scheduled area for purposes of § 312(a) (7) is estab- lished by § 306(e) (3). Similar treatment is provided for borrowings allocated to combined Schedules B/C under § 507 that are subsequently repaid in a year of electing § 504. Schedular apportion- ment of an aggregate deduction must also be made under § 306(e) (3) if the DI intends subsequently to reallocate be- tween scheduled areas. The rule of § 306(e) (3) does not apply to a deduction under § 313(d) (1), which REPRINTED FROM FEDERAL REGISTER, VOL. 35. NO. 195— WEDNESDAY, OCTOBER 7. 1970 16 RULES AND REGULATIONS is recognized in the scheduled area where the transfer of capital was made with available proceeds. (i) Recalculation of worldwide posi- tive direct investment under § 503 and combined Schedules B/C positive direct investment under § 507. Section 306(e) (3) deems a § 306(e) deduction to have been made in proportion to the amount of positive direct investment in each scheduled area (negative direct invest- ment being treated as zero for this pur- pose). DI should, therefore, recalculate direct investment for each schedule, taking into account all interschedular transfers (§505), dividends and profit remittances. Treatment of aggregate an- nual losses (former § 503(b)) in recal- culating 1969 direct investment by sched- uled area is discussed below in para- graph (iii) of this section. Example 9. DI elected § 503 for 1969 and made positive direct investment worldwide of $2 million. To comply with the regula- tions, DI made a long-term foreign borrow- ing of $1 million and allocated the proceeds to positive direct investment, under § 306 (e)(1). Assume that DI recalculates 1969 direct in- vestment by scheduled area as follows ($000 omitted) : Scheduled area Direct In vestment.. 1,000 (500) 1,500 Proportionate amount 40% 0% 60% DI's deduction under § 306(e) (1) is deemed by § 306(e) (3) to have been made as follows: Schedule A — $400,000 ($1,000,- 000X40%); Schedule B — 0; and Schedule C— $600,000 ($1,000,000:: 60%). Complete or partial repayment of the bor- rowing will be charged under § 312(a) (7) to each scheduled area in the same propor- tions (Schedule A — 40%; Schedule B — 0%; and Schedule C — 60%). The DI may also reallocate to other scheduled areas on the basis of the amounts apportioned to each area under § 306(e) (3). Example 10. Same facts as in Example 9. For 1970 DI elects § 507 and makes positive direct investment of $1,200,000 in Schedules B/C, consisting of $480,000 (40%) in Sched- ule B and $720,000 (60%) in Schedule C. DI reallocates under § 203(d) (3) to Sched- ules B/C $200,000 of the $400,000 deemed al- located to Schedule A in 1969. The realloca- tion to combined positive direct investment in Schedules B/C under § 203(d) (3) is deemed by § 306(e) (3) to have been made as follows: Schedule B (40%) — $80,000; and Schedule C (60 r i ) — $120,000. In 1971 DI elects § 504 and repays the bor- rowing in full. For purposes of § 312(a) (7), deductions in each area are as follows: Schedule A — $200,000 ($400,000 deemed al- located in 1969 less $200,000 reallocated in 1970); Schedule B— $80,000 ($80,000 deemed allocated in 1970); and Schedule C— $720,- 000 ($600,000 deemed allocated in 1969 plus $120,000 deemed allocated in 1970). Trans- fers of capital under § 312(a) (7) on account of the repayment will be charged to each area in the same amounts. (ii) Relation to § 313(d)(1) deduc- tions. If the DI also expended proceeds of the borrowing in making a transfer of capital, the § 313(d) (1) deduction will be recognized in the scheduled area where the transfer of capital was made, in addition to deductions deemed made in such area by § 306(e) (3) , as illustrated by the following example: Example 11. DI elected § 503 in 1969. Dur- ing 1969, DI borrowed $1,500,000 and ex- pended $500,000 in making transfers of capital to Schedule A, taking a deduction therefor under § 313(d) (1). DI also trans- ferred $500,000 each to Schedules A and B and $1 million to Schedule C. To comply with the regulations, DI allocated the $1 million of remaining available proceeds to worldwide positive direct investment, taking a deduc- tion under § 306(e) (1). DI's total deductions for purposes of § 312(a) (7) are: Schedule A — $750,000; Schedule B — $250,000; and Schedule C — $500,000, computed as follows ($000 omitted) : Scheduled area ABC (a) Net transfer of capital. 1,000 500 1,000 (b) Less § 313(d)(1) deduction.. 500 (c) Positive direct investment under § 306(a) 500 500 1,000 (d) § 306(e)(1) deduction (>) (e) § 306(e)(1) deduction ap- portioned under § 306(e)(3) on basis of.line (c) - 250 250 500 (f) Total deductions (Lines (b) and (e)) .- 750 250 500 i 1,000 worldwide. Complete or partial repayment of the bor- rowing in a subsequent year will be charged as follows if § 504 is elected: Schedule A — • 50 percent; Schedule B — 16% percent; and Schedule C — 33 '/ 3 percent. If § 507 is elected, the apportionment of the transfer of capital would be: Schedule A — 50 percent; Schedules B and C — 50 percent. Note, however, that if the $500,000 deduc- tion taken under § 313(d)(1) had been on account of a separate borrowing, repayments of that borrowing would be charged in full to Schedule A; and repayments of the borrowing allocated under § 306(e) would be charged only on the basis of the § 306(e) deductions as shown on line (e) of the above table (i.e., Schedule A — 25 percent; Schedule B — 25 per- cent; and Schedule C — 50 percent). An allo- cation under § 203(d) (2) would be made on the basis of the amount shown on line (b) of the table and reallocations under § 203 (d) (2) or (3) on the basis of line (e). (iii) Treatment of aggregate annual losses in recalculating 1969 direct invest- ment under § 503 by scheduled area. Sec- tion 503(b) in effect for 1969 required DIs to disregard aggregate annual losses in calculating worldwide direct invest- ment under the $1 million minimum allowable; i.e., the amount of such losses was to be added back to aggregate direct investment for all scheduled areas calcu- lated in accordance with § 306. See § B503-3(ii). In recalculating 1969 posi- tive direct investment for purposes of § 306(e) (3), the effect of the § 503(b) adjustment must be apportioned for each scheduled area. If a DI had aggregate annual losses for purposes of § 503(b) in 1969, direct investment should first be calculated for each scheduled area pur- suant to § 306(a), taking all losses into account. Then the DI should add to di- rect investment in each scheduled area in which annual earnings (§ 504(b) (4) ) were negative such scheduled area's share of aggregate annual losses, to be determined by multiplying aggregate an- nual losses by a fraction, the numerator of which is such area's negative annual earnings under § 504(b) (4) and the denominator of which is the sum of negative annual earnings for all areas where annual earnings were negative. See line (d) of the table in Example 13 below. Example 12. DI elected § 503 for 1969. DI had only incorporated AFNs in Schedules A and B. DI transferred $500,000 to Schedule A, where Its AFNs earned $500,000; and DI transferred $1 million to Schedule B, where its AFNs had losses of $1 million. No divi- dends were paid. DI had aggregate annual losses of $500,000 and positive direct invest- ment worldwide under § 503 of $1,500,000, calculated as follows ($000 omitted): Scheduled area B World- wide Reinvested earnings... 500 (1,000) (500) Net transfer of capital 500 1,000 1,500 Positive direct investment under §306 1,000 1,000 Add back aggregate annual losses _. 500 Positive direct investment under §503 _. 1,500 For purposes of the schedular recomputa- tion, aggregate annual losses are added to direct investment in the area where annual earnings were negative (Schedule B) in pro- portion to such area's share of all negative annual earnings (Schedule B — 100% ) . There- fore, DI's § 306(e)(1) deduction will be ap- portioned on the basis of $1 million positive direct investment in Schedule A and $500,000 positive direct investment in Schedule B. Example 13. DI elected § 503 in 1969. DI had only incorporated AFNs in Schedules A and B and unincorporated AFNs in Schedule C. DI made transfers of capital of $1 million to its AFNs in Schedule A and $3 million to its AFNs in Schedule B. DI's AFNs in Sched- ule A earned $500,000; the Schedule B AFNs lost $600,000, and the Schedule C AFNs lost $400,000 but had an increase in net assets of $100,000. DI's aggregate annual losses under § 503(b) , therefore, were $500,000. There were no dividends or profit remittances. DI's worldwide positive direct investment was $4,500,000. The following table illustrates the recalcu- lation by scheduled area of 1969 direct in- vestment ($000 omitted) : Scheduled area (a) Reinvested earnings 500 (600) (b) Net transfer of capital. 1,000 3,000 100 (c) Direct investment under §306(a) 1,500 2,400 100 (d) Adjustment for aggregate annual losses for purposes of § 306(e)(3) '300 ' 200 (e) Direct investment for pur- poses of § 306U') (3) 1,500 2,700 300 ' 500 X 600 H- 1,000 = 300. 2 500X400 •M,000=200. A deduction made under § 306(e), then, is deemed apportioned to the scheduled areas as follows: one-third to Schedule A; three- fifths to Schedule B; and one-fifteenth to Schedule C. (iv) Apportionment by other methods. If a DI is unable to recompute direct investment by scheduled area, the Office may, upon application, permit deductions to be apportioned on some other reasonable basis. REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 17 § B306-8 Calculation of direct invest- ment during year of acquisition or disposition of interest in an AFN. By operation of § 312(c)(1), acquisi- tion by a DI of a debt or equity interest in an AFN from another DI does not give rise to a transfer of capital. How- ever, if the acquisition is of an equity interest, the divesting DI's direct invest- ment in the AFN during the year of acquisition and in 1965-66 will be im- puted to the acquiring DI in proportion to the interest acquired, as will the di- vesting DI's share in earnings or losses of the AFN prior to acquisition. If a DI disposes of an AFN (other than by a transaction covered by § 312(c) (1)), the sale does not affect any transfers of capital between the DI and the AFN preceding the date of disposition. Thus, for example, if DI makes a $1 million transfer of capital to an AFN in January and sells the AFN in October to a foreign national for $900,000, DI would be charged with a $100,000 net transfer of capital during the year with respect to such AFN. If a DI sells an interest in an incor- porated AFN to a foreign national, rein- vested earnings attributable to the interest sold should not be included in computation of the DI's direct investment for the year of sale. Example 14. DI has a wholly owned in- corporated AFN in Schedule A. During 1969 DI sells a 40 percent interest in such AFN to a foreign national. The AFN earns $300,000 and pays no dividends. DI's share of rein- vested earnings of the AFN is $180,000 ($300,000 X 60 percent) , regardless of the date of divesture of the 40 percent interest. If a DI acquires an interest in an in- corporated AFN from a foreign national during a year, the DI must reflect a pro rata share of reinvested earnings in com- puting direct investment, based on the DI's share of total earnings multiplied by the fraction of the year during which the interest was held. Example 15. DI reports on a calendar year basis. On April 1, 1969, DI acquires from a foreign national a 100 percent interest in an incorporated AFN that earns $200,000 for the entire year and pays a $50,000 dividend on March 1 and a $75,000 dividend on Sep- tember 1. DI's share of total earnings is $150,000 ($200,000 X%). DI's share of rein- vested earnings is $75,000 ($150,000 — $75,000) . Note that the dividend paid prior to DI's acquisition is not reflected in the calculation of DI's reinvested earnings. Example 16. During 1969, DI acquires from a foreign national the following interests in an AFN: 25 percent on January 1, an addi- tional 30 percent on March 1 and an addi- tional 20 percent on September 1. The AFN earns $1,200,000 during 1969 and pays no divi- dends. DI's share of reinvested earnings in the AFN for 1969 is $680,000: $1,200,000 X (12/12) X25% equals... $300,000 $1,200,000 X (10/12) X30% equals. .. 300,000 $1,200,000 X ( 4/12) X20% equals... 80,000 Total 680,000 B31 2— TRANSFERS OF CAPITAL § B312-1 Introduction. Direct investment is defined in § 306(a) as the sum of a DI's net transfer of cap- ital and the DI's share of reinvested earnings of incorporated AFNs. Compu- tation of a DI's net transfer of capital (defined in § 313) is based upon the com- putation under § 312 of all transfers of capital from the DI to AFNs* and all transfers of capital from AFNs to the DI. Section 312 sets forth rules and defi- nitions for determining whether a given transaction constitutes a transfer of capital. In general, a transfer of funds or other property that increases a DI's aggregate equity and debt investment in an AFN (or decreases an AFN's aggregate equity and debt investment in a DI) is a "posi- tive" transfer of capital, i.e., a transfer by the DI to the AFN. Conversely, a transfer of funds or other property that decreases a DI's aggregate equity and debt investment in an AFN (or increases an AFN's aggregate equity and debt in- vestment in a DI) is generally a "nega- tive" transfer of capital, i.e., a transfer by the AFN to the DI. § B312— 2 Summary. Under § 312, transfers of capital by a DI to an AFN are defined in subsection (a) , transfers of capital by an AFN to a DI are defined in subsection (b), cer- tain transactions that are not considered transfers of capital are described in sub- section (c), and the definition of "debt obligation" or "debt interest" is set forth in subsection (d). Generally, transac- tions occurring during base period years and transactions occurring after the ef- fective date of the regulations are treated similarly in determining whether a transfer of capital has been made. Under § 312(a), any transfer of funds or other property (without regard to the situs of the property) by, on behalf of, or for the benefit of a DI, directly or indirectly to, on behalf of, or for the benefit of an AFN, is a transfer of capital by the DI to the AFN. Also, any trans- action or occurrence as a result of or in connection with which a DI directly or indirectly acquires or increases a debt or equity interest in an AFN, or the AFN directly or indirectly disposes of or re- duces a debt or equity interest in the DI, is generally a transfer of capital by the DI to the AFN. Under § 312(b), certain enumerated transactions or occurrences as a result of or in connection with which an AFN directly or indirectly acquires or in- creases a debt or equity interest in a DI, or the DI directly or indirectly disposes of or reduces a debt or equity interest in the AFN, are defined as transfers of capital by the AFN to the DI. The language of subsection (a) of § 312 is substantially broader than that of subsection (b) . Also, the specific trans- actions enumerated in subsection (a) as transfers of capital by a DI to an AFN do not purport to be all-inclusive; the transactions listed in subsection (b), however, are the only transactions which are considered transfers of capital by an AFN to a DI. A transaction between a DI and an AFN involving immediate cash payment for goods sold or services rendered is not a transfer of capital. However, if a DI sells goods on credit or renders services on account to an AFN, DI has made a transfer of capital to the AFN, since DI's debt investment in the AFN is increased. Subsequent payment on account by the AFN is a transfer of capital by the AFN to DI, since DI's debt investment in the AFN is thereby decreased. Aggregate transfers of capital by a DI to all AFNs in a scheduled area during a year, less aggregate transfers of capital by such AFNs to the DI during the year, is the "net transfer of capital" by DI to the scheduled area during such year. (See § 313.) A DI electing to be governed by schedular allowables under § 504 will report net transfers of capital on a schedular basis. A DI electing to be gov- erned by the minimum allowable under § 503 will report net transfer of capital on a worldwide basis. A DI electing to be governed by § 507 will report a net trans- fer of capital to Schedule A and a net transfer of capital to Schedules B and C combined. A DI's net transfer of capital may be a positive or negative amount; it will be a positive amount if the aggregate of transfers of capital by DI to AFNs exceeds the aggregate of transfers of capital by AFNs to DI. Particular transactions constituting transfers of capital during a year are not independently restricted under the regulations. A transfer of capital has significance only with respect to the com- putation, on an annual basis,' of a DI's net transfer of capital and direct investment. If proceeds of long-term foreign bor- rowing having been expended in trans- fers of capital (see § 313(d)(1)) or allocated to positive direct investment (see § 306(e) ) , repayment of the borrow- ing will be a transfer of capital by the DI. (See § 312(a) (7>.) Positive direct in- vestment attributable to such a transfer of capital may be authorized by § 1002, provided the certification requirements of that section have been met. Since positive direct investment in Canada is generally authorized without limitation as to amount (see § 1102), transfers of capital by a DI to Canadian AFNs may be made in unlimited amounts without contravening the regu- lations. However, a transfer of funds or other property by a Canadian AFN to a non-Canadian AFN of the DI will, under certain circumstances, be treated as a transfer of capital by the Canadian AFN to the DI, and as a further transfer of capital by the DI to the non-Canadian AFN. (See § 505.) Furthermore, if an interest is acquired in a Canadian AFN from another AFN, the transfer of capi- tal is deemed to have been made by a DI to the latter AFN; and if a DI acquires a Canadian AFN from any for- eign national (other than another AFN) , an appropriate portion of the transfer of capital by DI will be allocated among any non-Canadian second-tier AFNs owned by the Canadian AFN. The net transfer of capital by a DI to unincorporated AFNs in any sched- uled area during any period is computed in the manner set forth in § 313(b). REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 18 RULES AND REGULATIONS Transfers of funds or other property between AFNs of a DI are governed by § 505. In general, a transfer by one AFN to another AFN is treated as a transfer of capital by the transferor AFN to the DI, and a further transfer of capital in the same amount by the DI to the trans- feree AFN, provided that (a) at least one of the AFNs is an affiliate of the DI (i.e., the DI owns, alone or with other affiliates, a greater than 50 percent direct interest in the AFN) and (b) the trans- fer of funds or other property would be a transfer of capital under § 312(a) if actually made by the DI. (See § 505(a).) Extension of a trade credit for less than 1 year by one AFN to another AFN in the ordinary course of business normally will not involve a transfer of capital, provided neither AFN is Canadian. (See §§ 505(b) and 1103(c).) § B312-3 Valuation of transfers of capital. The amount of transfer of capital is ordinarily determined In accordance with generally accepted U.S. accounting principles consistently applied, but in no event will the amount be less than the value of the transferred property at the time of the transfer as shown on the books and records of the transferor for financial reporting purposes. Thus, for example, If a transfer involves an export credit sale by a DI to an AFN, the amount of the transfer will ordinarily be the intercompany billing price. If transfers of property are valued by a DI at amounts that differ materially from the intercompany billing price or the ex- port declaration value of the property (if applicable) , the DI's annual report including the transfers should contain a note to such effect and an appropriate explanation of the basis therefor. A transfer of capital arising from re- payment of a foreign currency loan from a DI to an AFN or from an AFN to a DI must be reported in U.S. dollars at the rate of exchange prevailing at the time of repayment, regardless of intervening devaluation or revaluation of the foreign currency. Likewise, a transfer of capital arising from repayment by the DI of an AFN's foreign currency borrowing pur- suant to the DI's guarantee thereof, or a transfer of funds by the DI to the AFN to enable the latter to repay a foreign currency borrowing, will be reported in U.S. dollars at the rate of exchange pre- vailing at the time of repayment. On the other hand, a transfer of capital arising from repayment by a DI of its own foreign currency long-term foreign borrowing will be charged at the dollar equivalent on the date of the borrowing, regardless of intervening devaluation or revaluation of the foreign currency. The effect of currency revaluation or devalu- ation on proceeds of long-term foreign borrowing is discussed in § B324-13. § B312— 4 Acquisition of interest in an AFN. Acquisition of an equity or profit In- terest in a foreign corporation, partner- ship or business venture (defined in § 304) by a person within the United States (defined in § 322) will involve a transfer of capital by such person under § 312(a)(1), or will be included in the calculation of the net transfer of capital to unincorporated AFNs under § 313(b), if: The person from whom the acquisition is made is either a foreign national (defined in §302), including the foreign corporation, partnership, or business venture in which the interest is acquired, or another person within the United States that is not, at the time of the acquisition, a DI in the foreign corporation, partnership, or business venture; and The person making the acquisition is, at the time of the acquisition, a DI in the for- eign corporation, partnership, or business venture under §§305, 905(b)(1) (members of an associated group treated as separate DIs) or 906(b) (3) (owners of a DI electing to be treated themselves as DIs) , or becomes a DI as a result of or in connection with the acquisition. If the acquisition is from a DI in the foreign corporation, partnership, or busi- ness venture, no transfer of capital is in- volved (§ 312(c) (1) ). Also, under certain conditions, OFDI will specifically au- thorize positive direct investment attrib- utable to a transfer of capital arising from an acquisition of an interest in a foreign corporation from non-DIs within the United States. A specific authoriza- tion may likewise be granted, under certain conditions, for positive direct in- vestment attributable to creation of a DI-AFN relationship by acquisition of a foreign corporation's assets in exchange for property (e.g., stock) of the new DI, where the foreign corporation is to be liquidated in a related transaction by distribution of the property received (e.g., stock of the DI purchasing the as- sets) to person' within the United States. If acquisition of an equity interest involves a transfer of capital by the DI, the transfer of capital will generally be deemed to have been made to the AFN in which the interest is acquired. There are, however, two exceptions to this rule. First, if the interest is acquired from an- other AFN of the DI, the transfer of capital will be deemed to have been made to the selling AFN. Second, if (a) the in- terest is acquired from an unaffiliated foreign national after December 31, 1967, (b) the AFN in which the interest is ac- quired first becomes an AFN as a result of the acquisition, and (c) such AFN has interests in other foreign corpora- tions, partnerships or business ventures that become separate AFNs of the DI as a result of the acquisition, the transfer of capital will be allocated among the sep- arate AFNs in a manner reasonably re- flecting the respective values of each di- rect and indirect interest acquired. As a general rule, an allocation based on the respective book values of the foreign cor- porations, partnerships and business ventures involved will be acceptable. Example 1. On June 1, 1969, a U.S. citizen and resident (X) , who owns no voting stock in a foreign corporation, purchases 10 per- cent of the outstanding voting stock of a French corporation (C) from a citizen and resident of the United Kingdom for $1 mil- lion cash. C has no subsidiaries or branches in Schedule A or B that would constitute separate AFNs under § 304. (a) Under the facts as presented, X has made a $1 million transfer of capital to C under § 312(a) (1). (b) If X had purchased only 9 percent of the voting stock of C, no transfer of cap- ital would be involved unless or until (i) additional stock acquisitions give rise to a DI-AFN relationship or (ii) OFDI determines that such relationship does, in fact, exist. (See §§ 305, 313(d) (2); see also § 304(b) (4).) (c) If X purchased only 9 percent of the voting stock of C, but X were a member of an affiliated, associated or family group, and an- other member or members of the group owned or acquired an additional 1 percent or more of the voting stock of C, X's acqui- sition would have involved a transfer of capital. (See §§ 903-905.) (d) If X had purchased only 9 percent of the voting stock of C, but X acquired an ad- ditional 1 percent or more of the voting stock of C between June 2. 1969, and May 31, 1970, X's net transfer of capital to Schedule C in 1969 or 1970 (depending on when the addi- tional stock was acquired) would be in- creased by the $1 million expended in pur- chasing the 9 percent interest on June 1, 1969. (See § 313(d) (2).) (e) If X had purchased 10 percent of C's outstanding preferred stock that has no vot- ing rights (other than contingent voting rights not presently exercisable), instead of 10 percent of the voting stock, X would not have made a transfer of capital to C. (See § 304(b) (2) (i).) (f) If X purchased 10 percent of the vot- ing stock of C and subsequently purchased nonvoting preferred stock of C for $1 mil- lion, purchase of the preferred stock would involve a $1 million transfer of capital to C. (See § 312(a) (1).) (g) If X purchased nonvoting preferred stock of C for $1 million and subsequently, within a 12-month period, purchased 10 per- cent of the voting stock of C, X's net trans- fer of capital to Schedule C during the year when the voting stock was acquired would be increased by the $1 million expended in pur- chasing the preferred stock. (See § 313(d) (2).) (h) If X had purchased C's voting stock from its Panamanian AFN (P), Instead of from the nonaffiliated United Kingdom resi- dent, the purchase would involve a transfer of capital to P, since acquisition of an equity interest in an AFN from another AFN of the acquiring DI is treated as a transfer of capital to the selling AFN. (i> If C had a wholly owned subsidiary In the United Kingdom (B) with net assets of $600,000, and a branch in Brazil (A) with net assets of $400,000 (calculated In accordance with § 313(b) ), and C itself had net assets of $1 million (exclusive of debt and equity In- terests in B and A), X's purchase of 10 per- cent of C's voting stock from the United Kingdom resident for $1 million would in- volve a transfer of capital required to be al- located among A, B, and _C. The $1 million transfer of capital made by X might be al- located $500,000 to C (I.e., 50 percent of $1 million), $300,000 to B (i.e., 30 percent of $1 million), and $200,000 to A (I.e., 20 percent of $1 million), or might be allocated among C, B, and A in any other manner fairly re- flecting the interests acquired in C, B, and A. (j) If C had a whoUy owned subsidiary in the United Kingdom (B) with net assets of $600,000, and a branch in Brazil (A) with net assets of $400,000, and C itself had net assets of $1 million (exclusive of its interests in A and B) , X's purchase of 10 percent of C's vot- ing stock from a Panamanian AFN (P) for $1 million would involve a $1 million trans- fer of capital to P, since no allocation among AFNs is made when the acquisition Is from another AFN of the acquiring DI. (k) If X had inherited 10 percent of the outstanding voting stock of C, or had re- ceived the stock as an inter vivos gift from REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 19 a relative residing in the United Kingdom, X would not have made a transfer of capital, since he would not have transferred funds or other property in connection with the acqui- sition of the equity interest in C (1) If X, after acquiring 10 percent of the outstanding voting stock of C, transfers equipment and machinery valued at $20,000 to C in exchange for additional stock of C, X has made a $20,000 transfer of capital to C. (See § 312(a) (1).) (i) Equity financing. A DI's acquisi- tion of an AFN from an unaffiliated for- eign national in exchange for stock of the DI involves a transfer of capital to the AFN in the amount of the value of DI's stock on the date of the acquisition. Deferral, in whole or in part, of a charge to DI's allowables for positive direct in- vestment attributable to such transfer of capital may be specifically authorized by OFDI under certain circumstances and subject to certain conditions. (See § B801 and Part I.E. of Appendix.) (ii) Contingent consideration. In con- nection with a DI's acquisition of an AFN (other than through equity financ- ing as described in (i) above) , to the ex- tent a payment by the DI is subject to the occurrence of a bona fide future con- tingency, such payment will involve a transfer of capital at the time when it is actually made. If the payment consists of stock or other property of the DI, the amount of the transfer of capital will be the value of the stock or other property at the time of the transfer. (iii) Unincorporated AFNs. Acquisition of an interest in an unincorporated AFN will be reflected as an increase in DI's share of the AFN's aggregate net assets, and will have significance under the reg- ulations only insofar as it contributes to yearend positive net transfer of capital or positive direct investment. Acquisition of an interest in an unincorporated AFN will be reflected as a transfer of capital under § 312(a) (1) ; similarly, it will have significance only insofar as a positive net transfer of capital or positive direct in- vestment results. Although earnings and losses of incorporated AFNs, are reflected as reinvested earnings and not in the de- termination of a DI's net transfer of capital, while earnings and losses of un- incorporated AFNs are taken into ac- count in determining a DI's net transfer of capital, the disparity arising from this difference in treatment of incorporated and unincorporated AFNs is minimized under the Program, since direct invest- ment is the sum of the net transfer of capital plus reinvested earnings. The following instances of similar or identical treatment of unincorporated and incorporated AFNs in transactions involving transfers of capital should be noted: The same rules regarding valuation of the interest acquired apply, whether the AFN is unincorporated or incorporated. The same rule and exceptions thereto ap- ply to determination of the AFN to which the transfer of capital will be deemed made, whether the acquisition is of an equity in- terest or of a profit interest. Normally, the transfer of capital will be to the acquired AFN. However, if the acquisition is made from another AFN, the transfer of capital will be to the selling AFN. Thus, DI's acqui- sition of an unincorporated AFN from an incorporated AFN will be reflected as a trans- fer of capital to the incorporated AFN, and not as an increase in the DI's share of the unincorporated AFN's aggregate net assets. Nevertheless, for future transactions the DI will be deemed to have the share in such AFN's net assets as was acquired on the date of acquisition. Also, if (i) the interest in the AFN is acquired after December 31, 1967, (ii) the interest is not acquired from another AFN, (iii) the AFN in which the interest is acquired is not, at the time of acquisition, an AFN of DI but becomes an AFN as a result of or in connection with the acquisition, and (iv) such AFN owns an interest or interests in other foreign entities that become sepa- rate AFNs of DI as a result of or in connec- tion with the acquisition, the transfer of capital will be allocated among all of the separate AFNs in a manner reasonably re- flecting the respective values of each direct and indirect interest acquired. In calculating the amount of net transfer of capital by a DI during any period, there is deducted an amount equal to proceeds of long-term foreign borrowing actually ex- pended in transfers of capital to incorporated AFNs or actually transferred to unincorpo- rated AFNs. (See § 313(d)(1).) § B312-5 Acquisition of an AFN's debt obligation. Acquisition by a DI of an AFN's debt obligation, regardless of the nature of the transaction or occurrence giving rise to the obligation (e.g., a loan or advance by the DI to an AFN on open account or otherwise ) , involves a transfer of capital by the DI to the AFN in an amount equal to the amount of the obligation so ac- quired. If, however, a debt obligation of an AFN is acquired by a DI from another AFN, a transfer of capital will be deemed to have been made by the DI to the sell- ing AFN in an amount equal to the cost of the obligation to the selling AFN ; any gain or loss realized by the selling AFN will be included in calculating earnings of that AFN for the period involved. The exemptions provided in § 312(c) (1) (relating to acquisitions from DIs) and § 312(c) (11) (relating to transfers of intangibles), and the provisions of § 313(d)(1) (relating to deduction of proceeds of long-term foreign borrow- ing) , are applicable to acquisition of debt obligations as well as to acquisition of equity interests. Example 2. The foregoing concepts are il- lustrated by the transactions considered be- low. In each instance, assume the DI has a 50-percent interest in a Mexican AFN (A). (a) DI lends A $500,000 against A's 3-year note and advances an additional $500,000 to A on open account. DI has made two $500,000 transfers of capital to A under § 312(a)(1). Repayments of each indebted- ness by A will involve transfers of capital from A to DI under § 312(b) (3), in the amounts repaid. (b) DI sells merchandise to A for resale and bills A for $100,000 payable within 60 days. DI has made a $100,000 transfer of capi- tal to A under § 312(a)(1). A repays DI dur- ing the same reporting period. The transfer of capital under § 312(b) (3) from A to DI will offset DI's transfer of capital to A, and no net transfer of capital will result from the transactions. It should be recognized that the transfer of capital from DI to A in this instance does not arise from the transfer of merchandise, but rather from the extension of credit involved in the transaction. If the total amount of credit outstanding in con- nection with the sale of merchandise by a DI to its AFNs increases during a year, OFDI may issue a specific authorization for posi- tive direct investment attributable to such increase in outstanding credit, subject to cer- tain conditions (see Part I.C. of Appendix hereto) . (c) DI ships merchandise on consignment to A for resale. A is to pay DI $100,000 when all the merchandise is sold. The shipment has the same effect under the regulations as a sale on credit, and involves a $100,000 transfer of capital by DI to A at the time of consignment. (d) DI renders management services to A, as a result of which A owes DI $10,000. DI has made a $10,000 transfer of capital to A under § 312(a)(1). Repayment of the in- debtedness will be a transfer of capital from A to DI under § 312(b) (3). (e) DI licenses A to manufacture and sell certain products for a royalty of 5 percent of A's gross sales of such products. Any accrual of unpaid royalties will involve a transfer of capital under § 312(a) (1). (f) A foreign bank lends $100,000 to A against A's 3-year note bearing interest at the prevailing rate. DI's acquisition of the note from the bank for $95,000 will involve a $95,000 transfer of capital by DI to A under § 312(a) (1). Repayment of the note by A will involve a $100,000 transfer of capital by A to DI under § 312(b) (3). (g) A declares a dividend to DI that is not actually remitted on the date payable. DI has acquired a debt obligation of A, and has made a transfer of capital to A under § 312(a) (1). Actual payment of the dividend will be a transfer of capital by A to DI under § 312(b) (3) . Note that for purposes of calcu- lating reinvested earnings, however, the divi- dend is deemed to have been paid on the date it becomes payable. (See § 306(d) (2) .) (h) Renewal of a loan from DI to A in a previous year will not involve a transfer of capital, since renewal is not deemed repay- ment of the old obligation or creation of a new obligation. However, accrual of unpaid interest on the loan will involve a transfer of capital to A under § 312(a)(1). Subse- quent payment of such accrued interest will be a transfer of capital by A to DI under 1312(b)(3). (i) DI sends A certain equipment to be repaired by A and returned to DI. No trans- fer of capital is involved. (j) Semiprocessed goods or raw materials are shipped by DI to A for processing or test- ing, and such goods or materials (title to which is retained by DI) will be returned to DI after processing or testing. No transfer of capital is involved. Payments by DI for the services rendered by A will not involve trans- fers of capital, but may be reflected in earn- ings of A. § B312— 6 Contributions by a DI to cap- ital of AFNs. Section 312(a) (2) is intended to cover a transfer of funds or other property by a DI to an AFN that is not reflected on the books and records of the DI or the AFN as either an acquisition of equity interest by the DI or creation of a debt obligation from the AFN to the DI. Thus, for example, if no stock is issued and no debt obligation is created in return for machinery shipped by a DI for use of an AFN, the DI will be deemed to have made a contribution of capital to the AFN (a transfer of capital under § 312(a) (2)) in the amount of the value of the machinery. If marketable securities owned by AFN increase in value, or fixed assets of an AFN are reappraised to increase their value, no transfer of capital to the AFN will result. Similarly, no transfer of capi- tal will result if an incorporated AFN capitalizes retained earnings. REPRINTED FROM FEDERAL REGISTER, VOL. 35. NO. 195— WEDNESDAY, OCTOBER 7, 1970 20 RULES AND REGULATIONS Expenses incurred by a DI in render- ing services primarily for the benefit of an incorporated AFN will not result in transfers of capital, under § 312(a) (2) or otherwise, provided such expenses are charged to the DI under generally ac- cepted U.S. accounting principles con- sistently applied. If such expenses are charged to the AFN and the DI is not compensated therefor, transfers of capi- tal under § 312(a) (1) or (2) will result. § C312-7 Repayment of DI's indebted- ness to an AFN. Any repayment by a DI of indebted- ness to an AFN will involve a transfer of capital by the DI to the AFN under § 312(a) (3), provided the AFN is still an AFN of the DI at the time of payment. If indebtedness is created in a transac- tion involving a transfer of capital from an AFN to a DI under § 312(b)(1), and is repaid by the DI during the same com- pliance period, no net transfer of capital will result. § B312-8 Reduction of an AFN's equity interest in a DI. Under § 312(a) (4), reduction of an AFN's equity interest in a DI as a result of a redemption of stock, liquidating divi- dend (whether or not any part is alloca- ble to earnings of the DI), or like transaction is a transfer of capital to the AFN. Thus, for example, if an AFN purchases stock of a DI from the DI for $1 million and the DI subsequently redeems the stock for $1 million, the AFN's purchase involves a $1 million transfer of capital to the DI under § 312 (b) (1) and the DI's redemption involves a $1 million transfer of capital to the AFN under § 312(a) (4). § B312— 9 Disposition of an equity or debt interest in a DI lield by an AFN. Whereas § 312(a) (4) encompasses those cases where an equity interest in a DI held by an AFN is reduced or liqui- dated by virtue of a redemption, liquidat- ing dividend or like transaction, § 312(a) (5) covers those cases where such an equity or debt interest of a DI is sold or otherwise transferred by an AFN to another person. Such disposition will in- volve a transfer of capital by the DI to the AFN only if (a) the interest is sold back to the DI, or (b) the selling AFN is an affiliate of the DI (as defined in § 903 (a)), or (c) the interest is sold to an- other AFN that is an affiliate of the DI. (See § 312(c) (2).) For example, an AFN that is an affiliate of a DI pur- chases stock of the DI from the DI for $1 million and subsequently sells the stock to an unaffiliated foreign national for $1.2 million. The AFN's purchase in- volves a $1 million transfer of capital from the AFN to the DI under § 312(b) (1) . Subsequent sale of the stock involves a $1 million transfer of capital to the AFN under § 312(a)(5), and a $200,000 capital gain to be reflected in calcula- tion of the AFN's earnings. § B312-10 DI's satisfaction of an AFN's debt obligation. Under § 312(a) (6), any payment by a DI to satisfy an obligation in respect of which an AFN is the primary obligor will involve a transfer of Capital by the DI to the AFN. Thus, for example, payment by a DI of an AFN's rent, salary ex- penses, advertising expenses, legal fees, auditing fees, or other expenses will in- volve transfers of capital to the AFN. Similarly, if a DI guarantees an obliga- tion owed by an AFN to another person, payment by the DI of any part of the principal amount of such obligation and payment of interest with respect thereto that has accrued prior to the AFN being relieved of or defaulting upon the obliga- tion, will involve a transfer of capital by the DI to the AFN. The making of a guarantee by a DI does not itself involve a transfer of capi- tal. (See §312(0(7).) However, a DI's assumption of an AFN's obligation in a transaction in which AFN is relieved of liability will involve a transfer of capital by the DI to the AFN, while subsequent payments of the obligation will not in- volve transfers of capital. Payment by a DI of interest on the obligation of an AFN after the DI has become primarily liable for the obligation does not involve a transfer of capital by the DI to the AFN. (See § 312(c) (8).) §B312-11 Repayment of a DI's long- term foreign borrowing. Repayment by a DI of a long-term foreign borrowing involves a transfer of capital by the DI under § 312(a) (7) , if proceeds of the borrowing were : Expended by DI in making a transfer of capital on or after January 1, 1965; or AUocated to a transfer of capital made by the DI during 1968; or Allocated to positive direct investment made during any year commencing with 1969. A transfer of capital under § 312(a) (7) is deemed to have been made to the scheduled area in which proceeds of the DI's borrowing were expended or are al- located at the time of the repayment. Positive direct investment attributable to a transfer of capital under § 312(a) (7) is generally authorized by § 1002(a), sub- ject, in certain instances, to the certifi- cation requirements of § 1002(b). See § B324-11. § B312-12 Lease of property by a DI to an AFN. Under § 312(a) (8), a lease of property by a DI to an AFN is considered a trans- fer of capital to the AFN if the property has a useful life at the time of the lease of 1 year or more, and is not required or expected to be returned to the DI in less than 1 year. This rule recognizes that long-term leases are substantially simi- lar in economic effect to outright trans- fers. Accordingly, such long-term leases of property by a DI to an AFN will be considered transfers of capital (in the amount of the market value of the property at the time of lease), without regard to the nature or expected use of the property, while a transfer of capital from the AFN to the DI will be recog- nized under § 312(b) when the property is returned to the DI in the amount of the market value of the property at such time. Payment of current rentals under such a long-term lease will not be considered a transfer of capital by the AFN to the DI (§ 312(c) (9) ), since rental payments are deducted in calculating the AFN's earnings. A sublease by a DI to an AFN will constitute a transfer of capital in any year only to the extent that the an- nual rental paid by the AFN to the DI is less than that paid by the DI to the lessor for the same year. Example 3. DI leases machinery and equip- ment to an incorporated AFN (X) for a 10- year term for a rental of $1,000 per year. The machinery and equipment have an aggregate value of $12,000 at the time the lease is made. At the end of 10 years, the machinery and equipment will be returned to DI, at which time it will have a value of $2,000. DI has made a $12,000 transfer of capital to X at the time of the lease and X will make a $2,000 transfer of capital to DI when the property is returned. The $1,000 annual rental payments will not constitute transfers of capital from X to DI. Example 4. On January 1, 1970, DI leases an office building in Germany from an un- affiliated foreign national for a term of 5 years at an annual rental of $30,000. On the same date DI subleases the property to its German AFN (C) for the same term at an annual rental of $20,000. DI has made a transfer of capital to C of $10,000 for 1970. DI will be charged with a transfer of capital in the same amount for each remaining year of the sublease. The treatment of leases or subleases between AFNs is illustrated in § B505-5. § B312— 13 Inducements for loans to a DI or to an AFN. Under § 312(a)(9), a DI's pledge, hy- pothecation, or transfer of foreign bal- ances (defined in 1203(a)(1)), or of equity securities of a foreign corpora- tion (other than equity securities of an AFN) , will involve a transfer of capital by the DI if the pledge, hypothecation, or transfer is made to or with a foreign national in connection with a loan to an AFN or a loan to the DI that qualifies a* long-term foreign borrowing and the proceeds of which are invested in an AFN. The amount of the transfer of capital for purposes of § 312(a) (9) is the lesser of (a) the value of the foreign balances or equity securities or (b) the amount borrowed by or invested in the AFN. The transfer of capital occurs as of the date the funds are borrowed by or invested in the AFN. For purposes of § 312(a) (9), proceeds of long-term foreign borrowing are deemed invested in an AFN if such pro- ceeds are expended in making a transfer of capital to such AFN or are allocated to positive direct investment in any one or more scheduled areas. A pledge or hypothecation constitut- ing a transfer of capital under § 312(a) (9) will, upon release, be considered a transfer of capital to the DI under § 312 (b) in the amount of the DI's initial transfer of capital. If, on the other hand, the property pledged or hypothe- cated is not released but is applied to payment of the secured indebtedness, no additional transfer of capital by the DI will result therefrom. Example 5. DI deposits $1 million (cash or securities) with a foreign bank as an inducement (or collateral) for an $800,000 loan by the bank to an AFN (X) . The deposit REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 21 is an $800,000 transfer of capital by DI to X. If cash wat deposited, only the $200,000 excess over the amount of the loan would constitute a liquid foreign balance (see § B203-4). The result would be the same if the deposit were made as collateral for an $800,000 long-term borrowing by DI from the foreign bank and the proceeds of the bor- rowing were loaned by DI to X. (The loan by DI to X would Involve a transfer of capital, with a corresponding deduction from net transfer of capital by operation of § 313(d) (1).) Similarly, if the collateral itself repre- sented proceeds of a long-term foreign bor- rowing, a deduction under § 313(d) (1) would also be taken in respect of the transfer of capital involved in the pledge. No transfer of capital under § 312(a) (9) would be Involved if the pledge or deposit were made as collat- eral for a short-term borrowing by DI. DI's loan of the proceeds of the short-term bor- rowing to X would involve a transfer of capital, but no deduction under § 313(d) (1) could be taken. Example 6. In September 1970, DI pledges $1 million of equity securities of a foreign corporation with a foreign bank as collateral for a $1 million long-term foreign borrowing by DI from such bank. For the year 1970, DI allocates $400,000 of the proceeds of such borrowing to positive direct investment in Schedule C and $300,000 to Schedule B un- der § 306(e). DI repatriates the proceeds as of yearend in accordance with *§ 203(d) (1) and 306(e)(2). Under § 312(a) (9), DI has made a transfer of capital of $400,000 to Schedule C and $300,000 to Schedule B. When the pledge is withdrawn, DI will re- port a negative transfer of capital from Schedule C of $400,000 and from Schedule B of $300,000. When DI repays the borrow- ing, there will be transfers of capital of $400,000 to Schedule C and $300,000 to Schedule B. Example 7. DI deposits $1 million with the home office of a domestic bank, as security for a $1 million loan by a foreign branch of the bank to an AFN (X). The deposit is not a transfer of capital, since it was not placed with a foreign national, but does constitute a guarantee by DI of X's borrow- ing. See § B1001-3. (In this connection, positive direct investment attributable to a subsequent transfer of capital pursuant to DI's guarantee (under § 312(a) (6)) will be authorized by § 1002(a) ;5), provided DI has complied with the certification requirements of § 1002(b).) Example 8. DI pledges equity securities of U.S. corporations, together with equity se- curities of an AFN, with a foreign bank as collateral for a loan by the bank to another AFN (X) or, alternatively, as collateral for a long-term borrowing by DI from the for- eign bank. The pledge is not a transfer of capital in either instance, since the secu- rities pledged are not those of an unaffiliated foreign national. (However, the pledge of securities as collateral for the loan to X would be considered a guarantee by DI of X's obligation.) Example 9. DI deposits $1 million with a foreign bank pursuant to an arrangement whereby the bank lends $1 million to an AFN (X). The deposit constitutes a $1 mil- lion transfer of capital by DI to X, whether or not the bank has a legal right to resort to the deposit should there be default by X. However, if DI's deposit was a deposit In the ordinary course of business, there would be no transfer of capital, in the absence of an agreement tfi.at the funus would stay on de- posit while the loan was outstanding, and the funds on deposit would constitute a liquid foreign balance. § B312— 14 Indirect transfers by a DI to an AFN. It is important to recognize that § 312 (a) focuses on the substance rather than the form of transactions. Transactions that do not come precisely within the language of any of the subparagraphs of § 312(a) , but nevertheless are undertaken by a DI for the benefit of an AFN, may involve a transfer of capital by the DI to the AFN even though the transactions are effected through nominees, financial conduits or other intermediaries. While the outcome of each transaction will de- pend on the specific facts and circum- stances involved, DIs should recognize the general rule that transactions ef- fected indirectly with an AFN will be treated under the regulations as if ef- fected directly by the DI. § B312-1S Transfers of capital by an AFN to a DI. The provisions of § 312(b), relating to transfers of capital by an AFN to a DI, are roughly parallel to the provisions of § 312(a) (l)-(6), relating to transfers from a DI to an AFN. Thus, with certain exceptions, any transaction that would involve a transfer of capital by a DI to an AFN under subparagraphs (1) through (6) of § 312(a) will involve a transfer of capital by the AFN to the DI under § 312(b) if the position of the par- ties is reversed (e.g., the AFN, rather than the DI, is the lender). The following points, however, deserve specific mention. (i) Acquisition by AFN of interest in DI. Under § 312(a) (1), acquisition of an equity or debt interest in an AFN will ordinarily involve a transfer of capital by the DI, regardless of the identity of the person from whom the interest is ac- quired; the only exception is an acquisi- tion from another DI. Under § 312(b), however, acquisition by an AFN of an equity or debt interest in a DI involves a transfer of capital by the AFN only if the person from whom the interest is ac- quired is the DI itself (§ 312(c) (3) ). Thus, for example, if an AFN lends $100,000 to a DI, a $100,000 transfer of capital from the AFN to the DI is in- volved under § 312(b)(1). If the loan were made to the DI by a bank and the AFN subsequently acquired the debt ob- ligation, no transfer of capital to the DI would be involved; however, satisfaction of the obligation by the DI would involve a $100,000 transfer of capital to the AFN under § 312(a)(3). (ii) Disposition by DI of interest in AFN. Disposition by an AFN of an equity or debt interest in a DI involves a transfer of capital by the DI under § 312(a) (5) if the selling AFN is an "affiliate" (defined in § 903(a)), or if the transferee is the DI or another AFN that is an affiliate of the DI. Under § 312(b) (5) , however, disposition by a DI of an equity or debt interest in an AFN involves a transfer of capital to the DI only if the transferee is either (a) a for- eign national or (b) a domestic bank or nonbank financial institution subject to the Federal Reserve Board's Voluntary Foreign Credit Restraint Program and the transfer is charged against the ceil- ing of such bank or is treated as a cov- ered asset of such institution under that program (§ 312(c) (4) ). Thus, if a DI lends $100,000 to an AFN (resulting in a $100,000 transfer of capital *o the AFN) and discounts the AFN's note for $98,000 with a domestic bank, a $98,000 transfer of capital by the AFN to the DI will re- sult if the bank is subject to the Volun- tary Foreign Credit Restraint Program and the note is charged against the bank's ceiling under thai program. The result would be the same if the note is discounted with a foreign bank (includ- ing a foreign branch of a domestic bank) or another foreign national. If the DI's disposition of the note did not involve a transfer of capital under § 312(b) (5), satisfaction of the note by the AFN would involve a transfer of capital to the DI. When a DI disposes of a debt or equity interest in an AFN (under circumstances constituting a transfer of capital to the DI under § 312(b) (5)), the transfer of capital to the DI is the full value of con- sideration received therefor, whether the transaction results in a gain or a loss to the DI. A transfer of capital under § 312(b) (5) will generally be deemed to have been made to the DI by the AFN that issued the debt or equity interest disposed of. There are, however, two exceptions to this rule. First, if the debt or equity in- terest in an AFN is sold by a DI to an- other AFN, the transfer of capital is deemed to have been made to the DI by the latter AFN. Second, if an equity interest in an AFN is both acquired from and sold to unaffiliated foreign nationals after December 31, 1967, and at the time of the disposition the AFN involved has subsidiaries or branches in other sched- uled areas that are separate AFNs under § 304, the transfer of capital to the DI should be allocated among all such AFNs in a manner fairly reflecting the respec- tive values of all direct and indirect in- terests in the AFNs disposed of. As a gen- eral rule, an allocation based on the book value of each AFN will be acceptable. Sale of an AFN to an unaffiliated for- eign national during a year does not af- fect any transfers of capital between the DI and the AFN preceding the date of disposition. Thus, if a DI makes a $1 million transfer of capital to an AFN in the beginning of the year and in Decem- ber sells all equity interest in the AFN to an unaffiliated foreign national for $900,000 in cash, the DI has made a posi- tive net transfer of capital of $100,000 to the scheduled area of the AFN (assum- ing no other relevant transactions dur- ing such year) . (hi) Accounts receivable. If an AFN assigns accounts receivable of unaffiliated persons to the DI in satisfaction of a debt obligation of the AFN held by the DI, a transfer of capital to the DI will be rec- ognized under § 312(b) (3) when the ac- counts are paid or are sold by the DI to an unaffiliated foreign national (or to a domestic bank or nonbank financial in- stitution subject to the Federal Reserve Program and the transfer is charged under such program) in the amount re- ceived by the DI. § B312-16 Sale of an AFN to an unaffil- iated foreign national with deferred payment. If a DI receives a debt obligation of an unaffiliated foreign national as consider- ation for an interest in the AFN dis- posed of, no transfer of capital to the DI REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 22 RULES AND REGULATIONS will result from the disposition until the obligation is paid or is sold by the DI to another unaffiliated foreign national for cash or other property (other than a debt obligation) , or to a domestic bank or nonbank financial institution subject to the Federal Reserve Voluntary Foreign Credit Restraint Program and the trans- fer is charged against the ceiling of such bank or is treated as a covered asset of such institution under that program. Example 10. DI sells 50 percent of the stock of a wholly owned French corporation (C) to an unaffiliated foreign national (F) for $1 million in cash. C has no subsidiaries or branches outside Schedule C. DI had origi- nally acquired all of the stock of C for $100,000. (a) Under the facts as presented, the sale involves a $1 million transfer of capital from C.to DI, pursuant to § 312(b) (5). (b) If F had given DI a note for $1 million instead of cash, the transfer of capital from C to DI would occur when the note is paid or is sold by DI to another unaffiliated for- eign national for cash or other property (other than a debt obligation). (c) If F had been an AFN of DI located in Schedule B, the sale of C for cash would involve a $1 million transfer of capital from F to DI. (d) If F had been an AFN of DI located in Schedule B and paid DI with a note for $1 million, DI's exchange of stock in C for a debt obligation of F would not involve a transfer of capital. However, payment of the note by F would involve a transfer of capital from F to DI, pursuant to § 312(b) (3). (e) If C had a subsidiary in Schedule A (X), a branch in Schedule B (Y) that was a separate AFN of DI, and a subsidiary in Schedule C (Z), the transfer of capital to DI involved in a cash sale of C to an unaffiliated foreign national would be allocated among C, X, Y, and Z in a manner reasonably re- flecting the respective values of each direct and indirect interest disposed of by DI. If C were sold to another AFN for cash, no alloca- tion of the transfer of capital to DI would be made among the second-tier AFNs; the transfer of capital under § 312(b) (5) would be from the acquiring AFN to DI. (f) The fact that DI had originally ac- quired C with proceeds of a long-term foreign borrowing would not alter any of the above results. § B312-17 Triangular and parallel financing. Triangular loan arrangements are gen- erally those in which a loan by a DI to an unaffiliated foreign national is the basis for, or is otherwise associated with, a loan by such foreign national to an AFN. Parallel loan arrangements are generally those in which a loan by a DI to a U.S. subsidiary of an unaffiliated foreign national is the basis for, or is otherwise associated with, a loan by such foreign national to an AFN. As stated in the instructions for spe- cific authorizations issued September 11, 1970 (see Part I.G. of Appendix hereto) , each such type of arrangement will gen- erally give rise to a transfer of capital by the DI to the AFN at the time and in the principal amount of the foreign loan to the AFN. However, such instructions indicate that relief will be available, sub- ject to certain conditions, in the form of a specific authorization to exclude the current charge against allowable result- ing from such transfer of capital. § B312— 18 Certain transactions not in- volving a transfer of capital; § 312(c). Section 312(c) sets forth particular transactions not deemed to involve trans- fers of capital although technically en- compassed by the language of § 312 (a) or (b). Under § 312(c) (1), acquisition by a DI of a debt or equity interest in an AFN (as described in § 312(a) (1)) will not be deemed to involve a transfer of capital if the acquisition is made from another DI. The selling party must be a DI at the time of the sale, but may cease to be a DI as a result of the transaction. Under certain conditions, OFDI may specifically authorize positive direct investment attributable to acquisition by a DI of an interest in an AFN from a person within the United States that is not a DI (i.e., a person holding less than 10-percent interest in the foreign national). See § B312-4. Under § 312(c) (1) (i), if a DI acquires an equity interest in an AFN from an- other DI, the divesting DI's direct invest- ment in the year of the acquisition and during 1965-66 is deemed to have been made by the acquiring DI, to the extent allocable to the interest transferred. Similarly, the divesting DI's share in the AFN's earnings or losses prior to acquisi- tion is attributed to the acquiring DI, to the extent allocable to the interest transferred. In calculating the divesting DI's direct investment in the AFN, de- ductions taken pursuant to §§ 203(d) (2) and (3), 306(e), and 313(d) (1) must be disregarded unless the acquiring DI as- sumes the obligation to repay the long- term foreign borrowing in connection with which the deductions were taken. The acquiring and divesting DIs must file revised Forms FDI-101 and FDI-102F for the year preceding the year of acqui- sition, reflecting the above treatment, in order for the acquisition to be covered by §312(0(1). As provided in § 312(c) (1) (ii) , an acquisition of an AFN as the result of a combination (by merger or otherwise) of two or more DIs will be treated as though the surviving DI were an acquiring DI under § 312(c) (1) (i) and the other par- ties to the transaction were divesting DIs. In the case of merger or other com- bination of DIs, OFDI should be con- sulted as to the applicability of any outstanding specific authorizations that were issued to such DIs prior to the merger. If the acquiring DI assumes an obliga- tion to repay long-term foreign borrow- ing that was certified under Subpart J by the divesting DI, the acquiring DI must file a revised standard certificate Form FDI-106 (together with the revised Forms FDI-101 and FDI-102F) in order for repayment of the borrowing to be authorized under § 1002(a) . See § B1002- 2 for discussion of certification on Form FDI-106. The revised certificate should identify the acquiring DI and the original certificate being replaced and should in- dicate that it is being filed in connection with an acquisition under § 312(c)(1). The information contained in Items n through V (Items 1-7 on prior Form FDI-106), including the date of the bor- rowing, of Form FDI-106 would presum- ably remain the same. As to Item VI (Item 8 on prior Form FDI-106) (basis for certification) , the acquiring DI may rely on the reasons stated by the divest- ing DI, if at the time of the acquisition the basis for such certification is still valid with respect to the remaining life of the borrowing. If the divesting DI certified on the basis of Item VI (a) (2) (or Item 8 A 2 or 3 on prior Form FDI-106) , the acquir- ing DI may, nevertheless, certify on the basis of Item VI(b)(l). Example 11. DI(l) made a long-term for- eign borrowing in 1969 and certified on the basis that the borrowing would be refinanced. In 1970, DI(1) merges into DI(2), which has substantial allowables that would be avail- able for repayment of the borrowing. In filing revised Form FDI-106, DI(2) may elect instead to certify on the basis of Item VI(b)(l). However, if the acquiring DI does not have sufficient allowables to justify cer- tification originally made on the basis of Item VI (b) (1) , the revised Form FDI- 106 must state some other basis. Example 12. DI(1), a § 504(a) reporter, made a long-term foreign borrowing in 1969 of $2 million, payable in full in 1972, which DI expended in Schedule B and certified un- der Subpart J on the basis of a $2,500,000 Schedule B historical allowable. In 1970 DI (1) is merged into DI(2), which had sub- stantial negative direct investment in Sched- ule B during 1965 and 1966, and as a result, the surviving DI has a Schedule B historical allowable of only $500,000. DI(2) may not file the revised Form FDI-106 on the basis of Item VI(b) (1). Certificates filed on the basis of the § 503 or § 507 allowable will continue to be valid for purposes of Subpart J even though the DIs relying on such allow- ables merge and consequently are en- titled to only one such allowable. Example 13. DI(1) and DI(2) each made a long-term foreign borrowing of $1 million in 1969 payable in 1971 and certified under Subpart J on the basis of their § 503 allow- ables. The borrowings were expended in Schedule C. In 1970, DIs (1) and (2) merge. Although the surviving entity will be en- titled to only one § 503 or § 507 allowable, repayment of both borrowings in 1971 will be authorized under Subpart J as originally certified. If a DI acquires a debt obligation of its AFN from another DI in the same AFN, no transfer of capital is involved and no allocation of direct investment between the DIs is made. Pursuant to § 312(c) (2), disposition of an equity or debt interest in a DI by an AFN involves a transfer of capital by the DI to the AFN under § 312(a) (5) only if (a) the interest is sold back to the DI, or (b) the selling AFN is an affiliate of the DI, or (c) the interest is sold to another AFN that is an affiliate of the DI. Pursuant to § 312(c) (3) , acquisition by an AFN of an equity or debt interest in a DI is no I a transfer of capital to the DI under § 312(b) (1) unless the acquisition is from the DI. Pursuant to § 312(c) (4), transfer by a DI of an equity or debt interest in an REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 23 AFN is not a transfer of capital by the AFN to the DI under § 312(b) (5) unless the transfer is made to a foreign national or is charged under the Federal Reserve Board's Voluntary Foreign Credit Re- straint Program. Under § 312(c) (5), increase of equity interest in an incorporated AFN result- ing from reinvestment of the AFN's earnings does not involve a transfer of capital. Reinvestment of the DI's share of an incorporated AFN's earnings does, however, constitute an element of direct investment, as defined in § 306(a). Under § 312(c) (6) , increase or decrease in the value of an AFN's assets resulting from reappraisal of such assets does not involve a transfer of capital. Under § 312(c) (7), a DI's guarantee of borrowing by an AFN does not itself involve a transfer of capital. (For a defi- nition of the term "guarantee", see § 1001(c).) However, payments pursuant to a guarantee may involve transfers of capital under § 312(a) (6) or (b)(6). Positive direct investment attributable to a DI's performance under a guarantee of an AFN's obligation will be authorized in excess of applicable allowables, pro- vided that in the case of a guarantee made on or after January 1, 1968 the DI has complied with applicable certifica- tion requirements of § 1002(b). Under § 312(c) (8), payment by the primary obligor of interest currently due, or fees or commissions in connection with borrowings, does not involve a transfer of capital. Prepayments of interest pursuant to customary lending practices or commercial transactions likewise do not involve transfers of cap- ital. (The fees or commissions referred to above include commitment and ter- mination fees, premiums, underwriters' commissions, original issue discounts, broker-dealer fees, legal and accounting fees, and other like items.) Thus, for example, an AFN's payment of interest on a loan from a DI, or vice versa, does not involve a transfer of , capital if the interest is paid when due. If not paid when due, however, an additional debt obligation will be created, involving a transfer of capital from the obligee to the obligor under § 312(a) (1) or (b) (1) and a transfer of capital in the opposite direction under § 312(a) (3) or (b)(3) when the additional obligation is paid. It should be noted that the exemption under § 312(c) (8) applies only to the primary obligor. Thus, payments by a DI, pursuant to a guarantee of an AFN's borrowing, of interest, commissions and fees owed by the AFN, are transfers of capital to the AFN under 1312(a)(6). See § B312-10. Under § 312(c) (9), payment of rental currently due under a lease, or prepay- ment of rental if customary under leases of the type involved, does not involve a transfer of capital. However, a lease of property by a DI to an AFN may involve a transfer of capital under § 312(a) (8). Under § 312(c) (10) , payment of royal- ties currently due by a licensee does not involve a transfer of capital, absent cir- cumstances indicating that such pay- ments are essentially equivalent to transfers of capital and are merely dis- guised as royalty payments. Likewise, prepayment of royalties will not be treated as transfers of capital if such prepayments are customarily made by licensees under similar license agree- ments. As in the case of interest pay- ments, the exemption under § 312(c) (10) applies only to payments by a primary obligor. Section 312(c) (11) provides, as a gen- eral rule, that a transfer of any of the following items does not involve a trans- fer of capital by a DI to an AFN, or-vice versa: Patents, copyrights, trademarks, trade names, trade secrets, technology, proprietary processes, proprietary infor- mation, and similar intangibles, and any rights, interests, contracts or applica- tions relating to the foregoing items. "Trade secrets, technology, proprietary processes, proprietary information and similar intangibles" as used in § 312(c) (11) means information or know-how in which the DI has a legally protected, proprietary right. The performance of services will not qualify under § 312(c) (11) unless such services are ancillary to a transfer of property which qualifies under § 312(c) (11). Generally, OFDI will consider a transfer of information or know-how to involve a transfer within the meaning of § 312(c) (.11) if the in- formation or know-how would qualify as property for purposes of tax-free ex- change treatment under section 351 of the Internal Revenue Code (1954). The exemptions of § 312(c) (11) are applicable regardless of the form of the transfer, or the consideration received in exchange therefor. However, DI's transfer of any of the foregoing intan- gibles to an AFN on or after January 1, 1968, is considered a transfer of capital by the DI if (a) the transfer represents a substantial departure from a previously established practice of the DI with re- spect to exploitation of intangibles of the type transferred, and (b) the intan- gible transferred was, prior to the trans- fer, a substantial source of royalty or other like fixed or. determinable, annual or periodic, income. If a post-January 1, 1968, transfer of an intangible does not involve a transfer of capital because of the foregoing rule, no deduction for amortization or any like charge with respect to the intangible transferred may be made against earn- ings in calculating the transferee AFN's earnings. Also, even if a transfer of in- tangibles does not involve a transfer of capital, a person within the United States making such transfer may become a DI if a 10-percent interest (as defined in § 304) in the foreign enterprise is received in exchange for the transfer. The determination whether transfer of an intangible represents a substantial departure from previously established practice and whether the intangible transferred was a substantial source of royalty or like income will depend on the facts and circumstances in each case. § B312— 19 Unenumerated transactions not involving a transfer of capital. Certain other transactions not enu- merated in § 312(c) will be deemed not to involve transfers of capital between a DI and an AFN, even though a foreign enterprise may become or cease to be an AFN as a result of the transactions. However, if a foreign enterprise ceases to be an AFN as a result of any such trans- action, this will not change the amount of direct investment chargeable to the DI during the base period in the appropriate scheduled area. The transactions refer- red to are as follows : Acquisition by a DI, from an AFN or un- affiliated foreign national, of stock or assets of a foreign corporation, partnership, or busi- ness venture in exchange for stock of an AFN; Contribution by a DI of stock or assets of an AFN to capital of another AFN; Merger of one incorporated AFN into an- other incorporated AFN of the same DI, or consolidation of AFNs of the same DI, or merger or consolidation of an AFN into or with the DI; Division of an AFN into two or more en- tities; and Recapitalization of an AFN involving an exchange of stock for stock, debt for debt, stock for debt, or debt for stock. A DI will not be exempt from recog- nizing a transfer of capital in a stock- for-stock /assets acquisition as described in the first category above if the ex- change in effect results in an acquisition for cash. Example 13. During 1970, DI organizes an Incorporated AFN (A) in Schedule A and contributes $20 million cash to the capital of A. DI then enters into an agreement with X, a foreign national, whereby DI acquires from X all of the stock of a French corpora- tion (C) in Schedule C In exchange for all of the stock of A. Thereafter, X causes A to be dissolved and the assets of A ($20 million cash) to be distributed to itself. This trans- action Is not a bona fide exchange of stock for stock, exempt from §§312 and 505, but Is equivalent to an acquisition of C for cash, and constitutes a transfer of capital from A to DI under § 312(b) and a transfer of capi- tal from DI to C under § 312(a) of $20 mil- lion. A DI will not be deemed to have made a transfer of capital to its AFN if the DI deposits funds with a foreign govern- ment or a foreign bank pursuant to an import deposit law, regulation or re- quirement of the foreign government in connection with exports made by the DI to the AFN. The foregoing rule applies only if the deposit is not returned or re- turnable to the AFN or otherwise carried on the books and records of the AFN as an asset or a debt obligation to the DI. § B312— 20 International construction projects. Bid preparation expenditures in con- nection with international construction projects are to be excluded from compu- tation of a DI's net transfer of capital, whether such expenditures have'been in- curred by the DI or it has advanced funds for such purpose to an AFN. How- ever, such expenditures may not sub- sequently be deducted in computing earnings of incorporated AFNs or ag- gregate net assets of unincorporated AFNs. Specific authorizations with re- spect to transfers of capital to foreign construction projects may also be granted in appropriate circumstances under § 801. REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 24 RULES AND REGULATIONS B313 — Net Transfer of Capital § B313— 1 Introduction. Net transfer of capital as defined in § 313(c) is one of the components of di- rect investment (§ 306). Net transfer of capital under § 313(c) consists of: The net transfer of capital to incorporated AFNs in a scheduled area (§ 313(a)); plus The net transfer of capital to unincorpo- rated APNs in the scheduled area (§ 313(b) ) ; less Expended proceeds of long-term foreign borrowing in the scheduled area (§313 (d)(1)). If the calculation produces a positive result, the DI has made a "positive net transfer of capital" to the scheduled area; if a negative figure results, the DI has made a "negative net transfer of capital" to the scheduled area. Section 313(d) (2) provides that trans- fers in connection with the acquisition of AFNs, including transfers during the 12- month period preceeding any such ac- quisition, must be included in computing net transfer of capital. Net transfer of capital to incorporated AFNs under § 313(a) consists of all § 312 (a) transfers of capital from the DI to AFNs, less all § 312(b) transfers from AFNs to the DI. The net transfer of cap- ital to unincorporated AFNs under § 313 (b) equals the DI's share in any net in- crease or decrease in the aggregate net assets of its unincorporated AFNs. While § 313 provides the basic defini- tion of net transfer of capital, § 505 con- tains additional rules essential to the application of § 313, viz: Transfers involving certain unincorporated APNs are treated as transfers of capital by the immediate parents or to the immediate parents of such AFNs (§ 505(a) (1), (2), and (3)); A DI Is charged with the net change in assets of an unincorporated AFN under § 313(b) only if the immediate parent of such AFN is the DI or another AFN that is a § 903(a) affiliate of the DI (§ 505(a) (4)); A change in net assets of an unincorpo- rated AFN that is not attributable to earn- ings or losses results in a corresponding § 312 (a) or (b) transfer of capital between the DI and the immediate parent of such AFN, provided the immediate parent is an incorporated AFN and a § 903(a) affiliate (§ 505(a) (5) and (6)); Certain short-term trade credits between non-Canadian AFNs are, in effect, excluded from the calculation of net transfer of cap- ital (§§ 505(b), 1103(c)); and Transfers between two incorporated AFNs, if either is a § 903(a) affiliate, result In a § 312(b) transfer by the transferor AFN to the DI and a § 312(a) transfer by the DI to the transferee AFN (§ 505(a) (3) ). The rules set forth in § 313 apply to the base period as well as to subsequent years. § B313— 2 Net transfer of capital to in- corporated AFNs. Under § 313(a), a DI's net transfer of capital to all incorporated AFNs in any scheduled area during any period con- sists of: Aggregate transfers of capital during such period by the DI to such AFNs (as described in §§ 312(a) and 505); less Aggregate transfers of capital during such period by such AFNs to the DI (as described in §§ 312(b) and 505). The following examples illustrate this concept. Example 1. During 1969, DI transfers $1 million to an incorporated subsidiary in Schedule A (AFN) as an advance on open account, $500,000 as a contribution to capi- tal, and $400,000 resulting from an increase in accounts receivable due from AFN to DI. In the same year, AFN repays $1,100,000 of a $2 million loan received from DI in 1967. DI has no other incorporated AFNs in Schedule A. DI's net transfer of capital during 1969 to AFN is $800,000, calculated as follows (000 omitted) : Transfers by DI under § 312(a) : Advance on account to AFN $1,000 Contribution to capital of AFN 500 Increase in accounts receivable from AFN 400 Total 1,900 Transfers to DI under § 312(b) : Repayment of loan by AFN (1,100) Net transfer (positive) 800 Example 2. At the beginning of 1969, DI has two wholly owned incorporated AFNs in Schedule A (X and Y) . In March 1969, DI purchases all the stock of a Brazilian cor- poration (Z) from an unaffiliated foreign national for $2 million in cash. The following transactions also occur during 1969 : DI lends $1 million to X on open account and leases equipment valued at $500,000 to X for a term of 3 years; X redeems (at cost) an issue of preferred stock held by DI for $500,000; Y repays a 1966 loan from DI of $3 million; Y declares a $200,000 dividend to DI, payable on December 15 but not remitted during 1969, and DI repays a $1 million loan owed by Y to a U.S. bank, together with accrued interest and other charges aggregating $100,000. DI's net transfer of capital during 1969 to its incorporated Schedule A AFNs (X, Y, and Z) is $1,300,000, computed as follows (000 omitted) : Transfer by DI under § 312(a) : Purchase of Z $2,000 Open account loan to X 1, 000 Lease of equipment to X 500 Dividend not paid by Y when due. 200 Payment on Y's loan 1, 100 Total 4,800 Transfers to DI under § 312(b) : Redemption by X (500) Repayment of loan by Y (3,000) Total (3,500) Net transfer (positive) 1,300 § B313— 3 Net transfer of capital to un- incorporated AFNs. (i) General. Under § 313(b), a net transfer of capital by a DI to all un- incorporated AFNs in any scheduled area during any period is defined as the DI's share of the aggregate net increase or decrease during such period in the ag- gregate net assets of such AFNs. Compu- tation of net assets should take into ac- count all assets (wherever located) and liabilities allocable to the AFN under generally accepted U.S. accounting principles consistently applied, whether such assets and liabilities are recorded in the AFN's legal books of account or in other books of account (including those of the parent AFN) . (ii) Rules applicable to % 313(b). In calculating the net change in net assets of an unincorporated AFN the following rules apply: There should be excluded from lia- bilities all equity interests in and debt obligations of the unincorporated AFN that are held by the DI and other AFNs of the DI; likewise, there should be ex- cluded from assets all equity interests in and debt obligations of the DI and other AFNs that are held by the unincorpo- rated AFN (§ 313(b) (1) and (2)). The foregoing rule does not apply with respect to short-term trade credits. That is, if another AFN extends a short-term trade credit to an unincorporated AFN of the same DI, the trade credit should be included as a liability of the unincor- porated AFN for the purposes of § 313 (b). The asset received and the liability incurred will net out, and there will be no change resulting therefrom in the AFN's net assets. Note that this is the result prescribed by § 505(b), i.e., short- term trade credits extended or received by an unincorporated AFN (to or from another AFN) should not be taken into account under § 313(b). On the other hand, if either the AFN extending the credit or the AFN receiv- ing the credit is Canadian, § 505(b) is inapplicable (§ 1103(c) ). Thus, if an un- incorporated AFN in Schedule C receives a short-term trade credit from a Cana- dian affiliate of the DI, the liability so incurred will be excluded and the AFN's net assets will include the amount of the credit for purposes of § 313(b). Any increase or decrease in net assets of an unincorporated AFN resulting from changes in the valuation of such assets during the period involved (such as unrealized gains or losses), should be eliminated from the calculation under § 313(b). However, depreciation of tan- gible assets should be taken into account to the extent such depreciation is re- flected in the calculation of the unincor- porated AFN's earnings. § B313— 4 DI's share of net change in assets under § 313(b). (i) Direct ownership. Where a DI directly owns an unincorporated AFN (e.g., a branch of the DI) , the DI's share in the net change in net assets will equal the profits (or losses) of the AFN plus all transfers of capital made by the DI (or other AFNs of the DI) to the AFN, less all remittances made by the AFN to the DI. When the DI does not own all of the unincorporated AFN, transfers be- tween the AFN and its other owners and such other owners' share of the AFN's profits or losses are not included in cal- culating the DI's share in the net change in the AFN's net assets. Example 3. DI has two branches in Sched- ule A (X and Y). Net assets of X and Y at the beginning of 1969 are $200,000 and $300,- 000, respectively. During 1969, X incurs a loss of $100,000 and DI transfers $50,000 to X on open account; Y earns $90,000, re- mitting $30,000 to DI; and DI spends $500.- 000 for construction of a factory in Schedule A, which becomes an unincorporated AFN (branch) (Z) of DI. At the end of 1969. X and Y have net assets of $150,000 and $360,000, respectively. DI's net transfer of REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 25 capital during 1969 to its unincorporated Schedule A AFNs Is $510,000 ($50,000 net decrease in X's assets plus $60,000 net In- crease in Y's assets plus $500,000 net increase in Z's assets) . Example 4. In March 1969, DI's unincor- porated AFN in Schedule A (Y) invests $50,000 of its own funds in a parcel of local real estate having a fair market value of $100,000 at the end of 1969. Assuming no other relevant transactions, Y's net assets would remain unchanged for purposes of the regulations, since unrealized gains are not taken into account under § 313(b). Example 5. DI has an unincorporated AFN (B) in Schedule B with net assets of $1 mil- lion as of December 31, 1969. During 1970, DI sells B to an unaffiliated foreign national for $1,200,000 cash. DI has made a negative net transfer of capital to Schedule B of $1,200,000 under § 313(b). Example 6. During 1969, a U.S. corporation (X) enters into a joint venture agreement with an unaffiliated foreign corporation (Y) to operate a factory in Schedule C. Y con- tributes an existing plant in Schedule C and equipment, valued in the aggregate at $10 million. X contributes patents and tech- nology valued at $5 million (under circum- stances exempting the contribution from treatment as a transfer of capital under section 312(c) (11)) and $5 million in cash for working capital. X and Y each has a 50- percent-profit interest in the joint venture. During 1969, a wholly owned subsidiary of X in Australia (B) lends $3 million to the joint venture, repayable at the end of 5 years. Also during 1969, the joint venture realizes $500,000 in gross revenues, spends $300,000 for operating expenses and depreciates its plant and equipment by $200,000. At the end of 1969, the joint venture has $8,200,000 in cash, patents valued at $5 million, plant and equipment valued on its books at $9,800,000, and no liabilities other than the $3 million liability to B. X's net transfer of capital dur- ing 1969 tp its unincorporated AFN's in Schedule C is $8 million, calculated as follows (000 omitted) : Net assets of joint venture as of Jan. 1, 1969 Net assets of joint venture as of Dec. 31, 1969 (the $3,000 loan by B is not included as a liability of the joint venture und,er § 313 (b)(1)): Plant and equipment $9, 800 Patents and technology 5,000 Cash 8,200 Total 23,000 Increase in net assets during 1969-1. 23,000 X's share in net increase: Net increase 23,000 Less: Plant and equipment contributed by Y 10,000 Patents and technology 5, 000 Net transfer of capital by X 8, 000 Note that the loan by B to the joint venture involves a transfer of capital by B to X under § 505(a) (1) and (2). Example 7. DI is a partner in a partnership organized under German law and doing busi- ness only in Germany. DI has a 50-percent share in the partnership profits. The other partners (X and Y) , each of whom has a 25-percent interest, are residents and citizens of Germany. At the beginning of 1969, the partnership has net assets of $1 million. Dur- ing 1969 the partnership earns $100,000 and distributes $20,000 to DI and $10,000 to each of X and Y. Also during 1969, DI lends $200,000 to the partnership on open account. At the end of 1969, the partnership has net assets of $1,260,000 (excluding liabilities to DI) . DI's net transfer of capital during 1969 to its unincorporated Schedule C AFN is $230,000 (i.e., DI's $50,000 share of profits plus the $200,000 loan, less the $20,00 remit- ted to DI). Had the partnership incurred a loss of $50,000 and made no distributions to the partners, the net assets at the end of 1969 would be $1,150,000 (excluding liabilities to DI), and DI's net transfer of capital during 1969 to its unincorporated Schedule C AFN would be $175,000 (i.e., the $200,000 loan less DI's $25,000 share of the loss) . (ii) Indirect ownership. A DI's net transfer of capital to all unincorporated AFNs in a scheduled area includes the DI's share of the net changes in the net assets of unincorporated AFNs in the scheduled area which are owned by other AFNs of the DI located in other sched- uled areas, so long as such other AFNs are "affiliates" of the DI, as described in § 903(a) of the regulations. (See §505 (a) (4) .) The calculation of any such net change should be made as if the DI it- self were the immediate parent of the un- incorporated AFN; the DI's share of the net change is a percentage thereof equal to the DI's percentage interest in the immediate parent. The following examples are illustra- tive: Example 8. DI has a 60 -percent- owned in- corporated AFN (A) in Schedule A, which has a 50-percent profits interest in a joint venture (B) in Schedule B. The other 50- percent interest in B is owned by an unaffil- iated foreign national (X). During 1970, A makes a $1 million loan to B, and as a re- sult B's net assets increase by $1 million. A's share of the increase is $1 million (see Example 7 above) ; and DI's share is $600,000 (i.e. 60% of A's share). DI has made a § 313 (b) net transfer of capital of $600,000 to Schedule B for 1970. By operation of § 505 (a) (6) , A is deemed to have made a $600,000 transfer of capital to DI. In 1971 B has earnings of $1 million, makes no remittances and has an increase in its assets of $1 million. A's share of such increase is $500,000, and DI's share is $300,000 (60% of A's share). DI has made a § 313(b) net transfer of capital of $300,000 to Schedule B for 1971. Example 9. DI has a wholly owned sub- sidiary in Germany (C) that has a branch in Brazil (A). At the beginning of 1969, A's balance sheet is as follows (000 omitted) : Assets Cash $75 Customer receivables 140 Inventory 360 Fixed assets (net) 400 Total 975 Liabilities and net assets Trade payables (liabilities) $210 Home office (net assets) 765 Total 975 During 1969, A earns $25,000 and DI and C each make cash advances to A of $75,000. On August 1, 1969, a wholly owned subsidiary of DI in Australia (B) sells $50,000 of inven- tory to A on 6-month credit terms. At the end of 1969, A's balance sheet is as follows (000 omitted) : Assets Cash $340 Customer receivables 175 Inventory 410 Fixed assets (net) 325 Total 1, 250 Liabilities and net assets Trade payables 1 $310 Home office account (net assets) 2 940 Total --,-_- 1, 250 'Including the payable of $50 [thousand] owed to B. If the credit terms extended by B had been for more than 12 months, the amount due would be included under the home office account rather than in "trade payables." DI's net transfer to A would, therefore, be increased by $50 [thousandj and result in a $50 [thousand] negative net transfer of capital to Schedule B (see § 505 (b) and 505(a) (2) ). 2 Including payable of $75 [thousand] owed to DI. DI's net transfer of capital during 1969 to Schedule A unincorporated AFNs is $175,000 (i.e., the increase in home office account (net assets) from $765,000 to $940,000 during 1969). However, DI will have a $75,000 nega- tive net transfer of capital to Schedule C (i.e., the $75,000 deemed transferred by DI to C by operation of § 505 (a) (1) and (a) (2) , less the $150,000 deemed transferred by C to DI by operation of § 505(a) (6) ) . . If DI owned only 80 percent of C's voting stock, DI's net transfer of capital during 1969 to Schedule A unincorporated AFNs would be $140,000 (i.e., $175,000 x 80 percent) . However, DI would have a $45,000 negative net trans- fer of capital to Schedule C (the $75,000 deemed transferred by DI to C by operation of § 505 (a) (1) and (a) (2), less the $120,000 deemed transferred by C to DI by operation of § 505(a) (6)). If DI were to own only 50 percent of C's voting stock, DI's net transfer of capital dur- ing 1969 to Schedule A unincorporated AFNs would be zero (see § 505(a) (4)). In this event, however, DI will have a $75,000 positive net transfer of capital to Schedule C, deemed transferred by DI to C by operations of § 505 (a) (1) and (a) (2). § B313— 5 Special treatment of certain § 312 transfers in computing net transfer of capital to unincorporated AFNs. A transaction involving an unincor- porated AFN that constitutes a transfer of capital under § 312 must be reflected in computing net transfer of capital to unincorporated AFNs under ? 313(b) even though it would not necessarily enter into the calculation of net assets in accordance with ordinary accounting principles. (i) Repayment of long-term foreign borrowing. Section 312(a) (7) provides that when a DI satisfies, in whole or in part, a long-term foreign borrowing (whenever made) and the proceeds of such borrowing were either expended in making transfers of capital on or after January 1, 1965, or were allocated to positive direct investment, such repay- ment constitutes a transfer of capital to the scheduled area or areas in which the proceeds were expended or allocated at the time of repayment and with respect to which a deduction (against net trans- fer of capital or positive direct invest- ment, as the case may be) was taken REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 26 RULES AND REGULATIONS pursuant to § 203(d), § 306(e), or §313 (d)(1). Example 10. In January 1968, DI makes a long-term foreign borrowing of $5 million from a London bank, the proceeds of which are used to construct a factory in Chile (Schedule A) resulting in a net increase in net assets of DI's Schedule A AFN in 1968 of $5 million (from $0 to $5 million) . DI deducts this expenditure from 1968 net transfer of capital to Schedule A, pursuant to § 313(d) (1). In 1969, the AFN has earnings of $450,- 000, and transfers $200,000 to DI. The net increase in net assets is, therefore, $250,000. On December 1, 1969, DI repays $1 million to the Iondon bank. Accordingly, DI's net trans- fer of capital to Schedule A in 1969 is $1,- 250,000 ($250,000 net increase in the Chilean factory's net assets, plus repayment of $1 million that had previously been expended in, and deducted from, net transfer of capital to Schedule A) . (ii) Transfers under § 312(a) (9). If DI makes a pledge, hypothecation or other transfer of foreign balances or equity securities of a foreign corporation to a foreign national to induce a loan by such foreign national to an AFN or a long-term foreign borrowing which DI invests in an AFN, such transfer of for- eign balances constitutes a transfer of capital to the AFN under § 312(a) (9). Example if . DI has a 50 percent profits in- terest in a Joint venture (B) located in Schedule B. During 1970 DI deposits $1 mil- lion cash with a foreign bank as inducement for a loan of $800,000 by the bank to B. Although the loan would not result in an increase in B's net assets under § 313(b), DI must recognize a transfer of capital of $300,000 to B under § 312(a) (9) during 1970. Similarly, it will report a transfer of capital under § 312(b) from B in the same amount when the deposit is withdrawn even though B's net assets may not decrease. (iii) Offshore drilling rigs. When a ves- sel directly owned by a person within the United States is used as part of an offshore drilling operation (i.e., a branch of a DI) , it is assigned a value of zero for purposes of computing any net change in net branch assets. Example 12. In January 1969, DI began drilling operations off the coast of Australia. This venture constitutes an unincorporated Schedule B AFN. In February 1969, DI sends its UJS.-flag barge to the worksite, and the barge Is used during 1969 In drilling opera- tions. Although transfer of the barge con- stitutes a transfer of capital to the AFN under § 312(a) , the barge Is assigned a value of zero for purposes of computing the net assets of the AFN. The same rule would also apply to other U.S. -flag vessels used in support of the offshore drilling operations (such as supply or crew vessels). Note that since such vessels are deemed to have a value of zero, no deduc- tions for depreciation of such vessels may be taken. § B313— 6 Deduction for expended pro- ceeds of long-term foreign borrow- ing. In calculating a DI's net transfer of capital to a scheduled area during any period (including the base period years of 1965 and 1966) , the DI should deduct an amount equal to the proceeds of long- term foreign borrowing (denned in 8 324 (c) ) expended during such period in making transfers of capital to AFNs In the scheduled area (§ 313(d)(1)). To be deductible under § 313(d)(1).. the borrowing must qualify as long- term foreign borrowing of the DI under § 324 (borrowings by AFNs will not qualify for the deduction). Under § 324(c), the gross amount of proceeds borrowed is deductible in calcu- lating net transfers of capital. In effect, therefore, DI is treated as having paid the interest and other charges on the borrowing out of its own funds (such payment not involving a transfer of capital) . Example 13. In September, 1970, DI ac- quires all the stock of a corporation in Ar- gentina from an unaffiliated foreign na- tional (Y) . The purchase price is $1 million, $500,000 payable in cash at closing and the balance payable in equal annual installments of $100,000 thereafter. Each installment is represented by a promissory note of DI, with respect to which Y makes the necessary written representations referred to in § 324 (a) (1) (iv). DI has made a $500,000 "foreign borrowing" within the meaning of § 324 (a) (1). Assuming the borrowing will qualify as long-term foreign borrowing under § 324 (a)(2), the proceeds thereof are to be de- ducted from DI's net transfer of capital un- der § 313(d) (1). DI's net transfer of capital to Schedule A during 1970 is, therefore, $500,000 (i.e., the $1 million purchase price, minus $500,000 proceeds of long-term for- eign borrowing) . Each principal payment by DI on the outstanding notes will constitute a transfer of capital to the AFN under § 312(a) (7), and must be so reflected in calculating DI's net transfer of capital to Schedule A in 1971 and in each subsequent year of payment. For a more detailed treatment of § 313 (d)(1) see§B324-8. § B313— 7 Step acquisitions. In calculating a DI's net transfer of capital to all AFNs in a scheduled area during any period (including the base period years of 1965 and 1966), the DI should include (a) all transfers of funds or other property as a result of which the DI acquires an AFN and (b) all transfers of funds or other property to, on behalf of, or for the benefit of such AFN made by, on behalf of, or for the benefit of such DI within 12 months prior to the date of the transfer by which it became a DI in such AFN. Example 14. On November 1, 1969, a U.S. corporation (X) having no AFNs acquires 8 percent of the voting stock of a French corporation (C) from an unaffiliated foreign national for $1 million In cash. On Decem- ber 1, 1969, X lends C $500,000. On March 1, 1970, X acquires an additional 2 percent of C's voting stock from a second unaffiliated foreign national for $250,000 in cash. X's net transfer of capital during 1969 to Schedule C is zero. X's net transfer of capital during 1970 to Schedule C Is $1,750,000. If the initial purchase of X's voting stock had been made on February 1, 1969, there would still be no net transfer of capital In 1969, and X's net transfer of capital during 1970 to Schedule C would be $750,000 (I.e., the $250,000 transfer of capital that gave rise to the DI-AFN relationship plus the $500,000 lent to C within 12 months prior thereto) . Example 15. On January 1, 1969, a U.S. cor- poration (X) , having no AFNs, enters Into a construction contract with an unaffiliated foreign national (Y) whereby X Is to con- struct a factory for Y In a Schedule C coun- try. On March 1 a project office is opened and preliminary survey work on the project Is commenced. On April 1, 1969, X sends equip- ment, machinery and supplies valued at $1 million to the project site. At the time the project office was opened, X reasonably ex- pected that the work would be completed by the end of February 1970. Thus, the project is not an AFN of X (see § 304(d) (ii) ) . At the end of 1969, net assets of the project are $1 million, but there has been no net transfer of capital to Schedule C during 1969 since the project is not an AFN. Significant diffi- culties of an unexpected nature are encoun- tered, and during 1970, X sends additional equipment, machinery and supplies valued at $1 million to the project site. At the end of 1970, the net assets employed in the proj- ect amount to $2 million. Work on the proj- ect is not in fact completed until March 1, 1971. Accordingly, since work on the project was not in fact completed within 12 months from the date it commenced, the project is an AFN of X commencing January 1, 1970, and, because of the provisions of § 313(d) (2) , X has made a positive net transfer of capital of $2 million to Schedule C during 1970. B31 9— Schedule A, B, and C Countries Section 319 assigns each of the coun- tries of the world to one of three scheduled areas. A, B, and C. Direct in- vestment made by a DI is generally cal- culated on the basis of a scheduled area, reflecting aggregate transactions involv- ing all AFNs in such schedule. The countries in Schedule A include those designated as less-developed coun- tries for purposes of the Interest Equali- zation Tax. The countries in Schedule B include certain designated countries such as Australia, Ireland, Japan, New Zealand, the United Kingdom, certain Middle East oil-producing countries and, commencing in 1970, Spain. The coun- tries in Schedule C include those not included in Schedule A or B, such as South Africa and the countries of con- tinental Europe other than Finland, Greece, Turkey, and Yugoslavia and, commencing in 1970, Spain. Section 319(b) was amended in 1970 to reclassify Spain from Schedule C to Schedule B as of January 1, 1970. Con- sequently, for 1970 and succeeding years DIs should include all direct investment in Spanish AFNs in calculating direct investment in Schedule B and should ex- clude such direct investment from the Schedule C computation. No change will be made in the base period figures used to calculate § 504(a) historical allow- ables or in any direct investment re- ported for 1968 and 1969. Furthermore, a DI's 1970 § 504(b) earnings allowable in Schedules B and C (based on 1969 earnings reported on the 1969 Annual Report Form FDI-102F) will not be changed. It is not necessary or permitted for any DI to amend or refile its Form FDI-101 or Forms FDI-102 and FDI- 102F for 1968 or 1969 as a result of the reclassification of Spain. However, 1970 earnings of Spanish AFN's will be in- cluded with other Schedule B earnings for purposes of determining a DI's 1971 § 504(b) earnings allowable and 1971 § 504(c) (3) upstream adjustment for Schedule B. The computation of the § 506 incremental earnings allowable, REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 27 being based on aggregate worldwide fig- ures, will not be affected as a result of this change. Although the Schedule B historical and earnings allowables in effect for 1970 will not be increased as a result of this change in the scheduled area to which Spain is assigned, DIs may downstream unused Schedule C allow- ables to Schedule B to cover any in- creased investment in Schedule B in 1970 and succeeding years. Example 1. DI has one AFN, which is located in Spain, and § 504(a) allowables of $1,200,000 in Schedule C and zero in Sched- ules B and A. In 1970 DI elects § 504(a) and makes positive direct investment of $1 million in its Spanish AFN. DI should report positive direct investment in 1970 of $1 million in Schedule B and zero in Schedule C. The Schedule B investment is authorized by DI's Schedule C allowable, under the carrydown provisions of § 504(d) (3). DI will have $200,000 of carryforward under § 504(d) (3) which will authorize additional positive di- rect investment in Schedules C, B, or A in 1971 and succeeding years. Example 2. DI has one AFN, which is lo- cated in Spain. The AFN's 1969 earnings are $4 million. DI's § 504(a) historical allowables are $800,000 in Schedule C and zero in Sched- ules B and A. In 1970, DI elects the § 504(b) earnings allowable and makes positive direct investment of $1,200,000 in its Spanish AFN, which is correctly reported in Schedule B. This positive direct investment is authorized by DI's Schedule C earnings allowable of $1,200,000 which is available in Schedule B under § 504(d) (3). Example 3. DI has one AFN which is lo- cated in Spain. At the end of 1969, the AFN owed DI $1 million on open account. In March 1970, the AFN pays DI $1 million in satisfaction of the open account balance. In October 1970 AFN is billed $1,500,000 for a shipment of goods, so that the open account balance at the end of 1970 is $1,500,000. In 1970, DI has made a net transfer of capital to Schedule B of $500,000. If a DI expended proceeds of long- term foreign borrowing in making trans- fers of capital to Spanish AFNs prior to 1970 and took a deduction from net transfer of capital to Schedule C under § 313(d) (1), repayment of such borrow- ing on or after January 1, 1970, will con- stitute a transfer of capital to Schedule C (not Schedule B) under § 312(a) (7). B321 — Calendar Year and Fiscal Year The term "year", as used in the regu- lations, is defined in § 321(a) to mean a calendar year except for DIs securing permission under § 32Kb) to measure compliance on the basis of their normal fiscal year. Although, in appropriate cases, a fiscal year DI may be permitted to comply with the substantive provisions of the regulations on such basis (§ 321 (b) ) , all DIs (including all fiscal year DIs) are required to submit cumulative quarterly reports (Form PDI-102) and the annual report (Form FDI-102F) on a calendar basis. DIs receiving permis- sion to measure compliance on a fiscal year basis must file an additional annual compliance report covering operations for such fiscal year. DIs may request permission to com- ply with the regulations on a fiscal year basis by applying for a specific exemp- tion under § 801. The applicant must demonstrate that by reason of the nature of its business, accurate reflection of total annual operations for purposes of the regulations can only be on the basis of its fiscal year. DIs maintaining normal books and records on a calendar year basis are not eligible for relief under § 32Kb) merely because one or more AFNs operate on a fiscal year basis. DIs should refer to the general instructions to Forms FDI-102 and 102F with respect to reporting earnings of AFNs that oper- ate on the basis of a fiscal year different from the DI's. B322 — Person Within the United States § B322-1 Introduction. The regulations apply only to DIs, and a person is not a DI unless he (or it) is a "person within the United States," as defined in § 322. (The term "United States" is defined in § 318.) § B322-2 Individuals. (i) Residence. Section 322(a) (1) pro- vides that a resident of the United States is a person within the United States. This rule applies without regard to citizenship. The determination whether a person is a "resident" of the United States de- pends on the facts and circumstances of each particular case. In general, a permanent place of abode within the United States or physical presence in the United States for more than 183 days during the year will be conclusive. However, aliens will not be considered residents of the United States if they have no intention to remain in the United States permanently or for an in- definite period. Thus, for example, an alien present in the United States as a student, an entertainer on tour, an athlete competing in one or more athletic contests, a patient undergoing medi- cal treatment, or a traveler will not be treated as a resident of the United States. Residence in the United States •will be treated as continuous notwith- standing occasional trips out of the country during such residence. (ii) Center of economic interest. Sec- tion 322(a). (2) provides that a citizen of the United States residing abroad is nevertheless a person within the United States, if the center of his economic interests is located within the United States. Whether a U.S. citizen's center of economic interests is located within the United States depends on the par- ticular facts and circumstances of each case. Among the factors that will be considered are the length of time resi- dence has been outside the United States, the person's intention concerning future residence, the relative values of investments in the United States and in foreign countries, and the nature of the U.S. investments (i.e., whether pas- sive portfolio investments or active par- ticipation in business is involved) . Example 1. A U.S. citizen (X) becomes a resident of a foreign country in February 1968. X owns all the stock of a U.S. corpora- tion (T). After X becomes a nonresident of the United States, he nevertheless continues actively to participate in Y's business and makes frequent trips to the United States for this purpose. X's only other investments are of a portfolio and short-term debt nature. X is a person within the United States. Example 2. A U.S. citizen (X) owns a retail merchandising business in the United States. Upon reaching age 65, X sells his business to an unrelated person within the United States and purchases an annuity from a U.S. insurance company. In Janu- ary 1968, X sells his home in the United States and he and his wife move to Iceland, X's ancestral homeland, where he establishes a permanent residence. X's grown children continue to live in the United States. X continues to maintain bank accounts in the United States, into which periodic payments from the proceeds of his annuity are made. X also continues to own a small parcel of un- developed real estate in the United States, purchased many years ago for investment. X is not a person within the United States. Example 3. A U.S. citizen (W), resident in a foreign country for many years, owns 75 percent of the stock of X and Y, both U.S. corporations. Y owns 75 percent of Z, a third U.S. corporation. X owns all the share capital of 6 foreign corporations and has 12 branch operations in foreign countries, and Y owns all the share capital of six different foreign corporations and has 10 branch operations in foreign countries. X, Y, and Z all have substantial manufacturing or selling opera- tions in the United States. The products of X, Y, and Z are sold both in the United States and in foreign countries. Total sales of X, Y, and Z and their 12 foreign affiliated corporations and 22 foreign branches amount to several million dollars annually. All major policy decisions of X, Y, and Z and their affiliated foreign nationals are made by W, who maintains no fixed office abroad. Decisions on particular matters within the policy guidelines laid down by W are made at the head offices of the three U.S. corpora- tions and are relayed to all domestic and foreign operations from such head offices, subject only to the periodic review of W. W conducts no significant separate foreign business activities aside from those con- ducted through his direction of the affairs of X, Y, and Z corporations. W is a person within the United States. Example 4. A U.S. citizen (X) owns all the stock of Y, a U.S. corporation with extensive, worldwide foreign operations. In 1965, X establishes his permanent residence in Bel- gium, and C, a foreign corporation, in Bel- gium. In September 1966, C purchases all the stock of Y from X, in exchange for addi- tional shares in C. In a series of corporate reorganizations carried out in 1966 and 1967, the foreign operations formerly conducted by Y and the foreign corporations previously owned by Y become foreign operations and corporations conducted and owned, respec- tively, by C. Direction of all such operations is carried on in Belgium; the head offices and senior managerial staff are moved to Belgium; and by December 1967, Y has no foreign holdings of its own. X is not a person within the United States in 1968. Example 5. A U.S. citizen (X) , having per- manently resided in Italy since 1961, owns several parcels of undeveloped and commer- cial real estate in the United States with an aggregate fair market value in excess of $10 million in January 1968. The commercial real estate is managed for X by an inde- pendent real estate organization, and profits are remitted to X periodically. X maintains certain bank accounts in the United States in connection with his real estate invest- ments. His only other U.S. investments con- sist of marketable securities of large U.S. cor- porations. X makes one or two trips per year to the United States, primarily to visit relatives. X has no significant investments in foreign countries. X is not a person within the United States. REPRINTED FROM FEDERAL REGISTER, VOL. 35. NO. 195— WEDNESDAY, OCTOBER 7, 1970 28 RULES AND REGULATIONS § D322-3 Corporations or partnerships. Section 322(a) (3) provides that a cor- poration or partnership organized under tne laws of the United States (excluding a branch of such corporation or partner- ship, if the branch is a separate foreign national under § 302) is a person within the United States. § B322-4 Trusts. Trusts (other than a trust deemed to be a corporation under § 307(b) ) deemed to be persons within the United States, under § 322(a) (4), include inter vivos or testamentary trusts established by per- sons within the United States in which a person or persons within the United States have substantial beneficial in- terest. An inter vivos trust governed by the laws of the United States to which any property is or has been contributed by a person who, at the time of making the contribution, is or was a person within the United States would be governed by 5 322(a)(4), if: (a) Such contribution is or was made on or after January 1, 1968; or (b) the terms of the trust are such that the income therefrom is cur- rently taxable to such persons for U.S. Federal Income Tax purposes; or (c) a majority of the trustees thereof are or were, at any time after January 1, 1968, persons within the United States and OPDI has not been furnished with satis- factory evidence that no person or per- sons within the United States have a substantial beneficial interest in the trust. A testamentary trust governed by the laws of the United States and created by a person who, at the time of his death, was a person within the United States, would likewise be governed by § 322(a) (4) , if a majority of the trustees thereof are or were, at any time after January 1, 1968, persons within the United States and OFDI has not been furnished satis- factory evidence that no person or per- sons within the United States have a substantial beneficial interest in the trust. § B322-5 Estates. A decedent's estate is deemed to be a person within the United States under § 322(a) (5) , if the deceased was a person within the United States at the time of his death, and: (a) A majority of the executors or administrators are persons within the United States, or substantial assets of the estate are being adminis- tered under the laws of the United States; and (b) OFDI has not been furnished satisfactory evidence that no person or persons within the United States have a substantial beneficial in- terest in the estate. § B322-6 Domestic banks. Section 322(a) (6) makes clear that a domestic bank (including a domestic branch or office of a foreign bank), as defined in § 317(a), will be considered a person within the United States. § B322-7 Special cases. Under § 322(b) , OFDI may determine, in particular cases based on the facts and circumstances involved, that a per- son not described in § 322(a), or an ac- tivity (such as a branch) of a person not described in § 322(a), is nevertheless a person within the United States for pur- poses of the regulations. Example 6. Corporation Y, a foreign cor- poration, has no managerial office or opera- tions in the country of incorporation. Ninety-five percent of Y's share capital is held by persons within the United States and shares are traded on a national securities exchange in the United States. The princi- pal office of Y is in the United States and all officers and directors are citizens and resi- dents of the United States. Y owns more than 10 percent of the share capital (in propor- tions ranging from 15 percent to 100 percent) of more than 20 foreign corporations. Under the foregoing facts, Y could be deemed a person within the United States for purposes of the regulations. B323 — International Finance Subsidiaries Section 323 defines the term "interna- tional finance subsidiary" ("IPS") to mean a corporation organized under the laws of the United States, all the stock of which (disregarding directors' quali- fying shares) is owned directly or indi- rectly by a DI, and the principal business of which is to borrow funds from foreign nationals, other than AFNs of the DI, and to invest such funds in debt or equity securities of AFNs of the DI. The section further provides that a DI and its IPS are considered a single person for all purposes of the regulations. Accordingly, direct investment .trans- actions of, and foreign balances held by, an IFS are attributed to the DI, and transactions between the DI and the IFS are ignored for purposes of the regu- lations. Similarly, long-term foreign borrowings obtained by the IPS are con- sidered borrowings by the DI, and only one certificate need be filed by the DI under § 1002 (a) (6) and (b) concerning each such borrowing. Therefore, if the DI guarantees due and punctual pay- ment of the principal, premium (if any) , and interest on debt obligations of the IFS, together with due and punctual mandatory sinking fund payments (if any), the DI should file the "Subpart J" certificate as a borrower, not a guar- antor, and any payments made by DI under the guarantee (including delivery of capital stock of DI pursuant to exer- cise of conversion privileges) will be treated as repayments by a borrower and not by a guarantor. In light of the foregoing, records maintained pursuant to §§ 203(c) and 601, and reports filed under § 602, by the DI should include all relevant items attributable to the IFS. B324 — Long-Term Foreign Borrowing § B324-1 Introduction. Section 324 sets forth the rules govern- ing the qualification of borrowing by a DI as long-term foreign borrowing and the amount of proceeds of long-term foreign borrowing that may be used as an offset in calculating direct investment. In addition, § 324 deals with the effect of refinancing and repayment of borrow- ings. Related provisions of the regula- tions concerning the use of proceeds and the repayment of long-term foreign borrowing are also discussed in this sec- tion of the Bulletin. DI may offset direct investment either through a deduction from net transfer of capital under § 313(d)(1) for expendi- ture of proceeds of long-term foreign borrowing or through a deduction from positive direct investment by allocating such proceeds under § 306(e). Only pro- ceeds of a borrowing that qualifies under § 324 as long-term foreign borrowing may be used as an offset to direct investment. Section B324-4 contains a detailed description as to how borrowing qualifies as long-term foreign borrowing. The re- quirements for qualification depend upon when the borrowing was made. . The gross amount of funds or other property received from long-term foreign borrowing constitutes "proceeds of long- term foreign borrowing" until the under- lying borrowing is repaid. Proceeds are "available proceeds" until expended in making transfers of capital to AFNs or allocated to positive direct investment. Only available proceeds of long-term foreign borrowing are deducted from net transfer of capital under § 313(d) (1) or from positive direct investment under § 306(e) . After deduction for expenditure or allocation, the amount of the borrow- ing outstanding still constitutes proceeds of long-term foreign borrowing but ceases to be available proceeds. As pro- vided in § 203(d) (2) and (3), a DI may change the scheduled area to which the offset applies. (See § B324-10.) For ex- ample, if a DI expended and deducted (under § 313(d)(1)) available proceeds of long-term foreign borrowing in Schedule A, those proceeds could sub- sequently be allocated to and deducted from positive direct investment in Schedule B (under § 203(d) (2)). Upon such allocation to Schedule B, however, DI must recognize a transfer of capital to Schedule A, where the previous de- duction was taken. Section 203(d)(2) also permits further allocations of the proceeds while the borrowing is out- standing, with the same effects. Proceeds originally expended and subsequently allocated to a different scheduled area under § 203(d) (2) may remain expended in an AFN or may be expended in an- other AFN, but no deduction under § 313(d)(1) may be taken for such expenditure. Repayment (in whole or in part) of a long-term foreign borrowing for which a direct investment offset was taken is recognized as a transfer of capital (§ 312(a) (7) ) in the last scheduled area in which a deduction was taken, whether under § 306(e), § 313(d) (1), § 203(d) (2), or § 203(d) (3). If deductions were last taken in more than one scheduled area, the charge is made on a proportional basis among the scheduled areas. The regulations require a DI to keep separate books and records with respect to long-term foreign borrowings and the uses to which the proceeds of such bor- rowings have been put. Such records must distinguish between deductions taken by reason of the borrowing and the actual flow of funds. (See § 203(b) .) REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 29 § B324-2 Related sections. The following sections of the regula- tions relate to long-term foreign borrowing: (i) Section 1002. Even though a trans- fer of capital is recognized upon repay- ment of a long-term foreign borrowing the proceeds of which were expended or allocated, positive direct investment re- sulting from such repayment may be authorized by § 1002 (subject to the provisions of § 1003) if DI has satisfied applicable certification requirements. (ii) Section 203(c). A DI is permitted to hold available proceeds of long-term foreign borrowing in the form of liquid foreign balances without limitation in amount. (iii) Section 203(d) (1). A positive net transfer of capital (subject to certain exemptions) to any scheduled area is prohibited during any year if a DI holds available proceeds of long-term foreign borrowing in the form of foreign prop- erty at the end of such year. (iv) Subpart N. Proceeds of an over- seas borrowing that are loaned by a qualified overseas finance subsidiary to the DI in proceeds borrowing are deemed available proceeds of long-term foreign borrowing as denned in § 324(d). (See § B1403-1.) § B324-3 Summary of § 324. Section 324 has been amended with re- spect to borrowings made on or after May 1, 1970. These amendments were published in final form in the Federal Register on June 13, 1970 (35 F.R. 9248) . The following summary compares the structure of § 324 before and after the 1970 amendments. Prior to amendment the provisions of § 324 were as follows: (a) Definition of long-term foreign bor- rowing applicable to (i) borrowings made prior to January 1, 1968, and (ii) borrow- ings made on or after January 1, 1968. (b)(1) Effect of refinancing. (b) (2) Effect of conversion of convertible debt instruments. (c) Definition of proceeds. (d) Definition of available proceeds. (e) Requirements in addition to those of § 324(a) applicable to borrowings made on or after June 10, 1968. The provisions of § 324 as amended are as follows : (a)(1) Definition of foreign borrowing (incorporating the conditions of former 5324(e)). (a)(2) Definition of long-term foreign borrowing applicable to borrowings made on or after May 1, 1970. (a)(3) Definition of long-term foreign borrowing applicable to borrowings made prior to May 1, 1970 (by reference to former § 324) . (b) (1) Definition of refinancing (amended to conform to new § 324(a) ) . (b) (2) [Unchanged] ( c ) [ Unchanged ] (d) [Unchanged] (e) [Revoked] § B324— 4 Definition of long-term for- eign borrowing. To qualify as long-term foreign bor- rowing under § 324 a borrowing must be made by a DI from a foreign national, other than an AFN or a Canadian per- son as described in § 1106. See former § 324(a) and new § 324(a) (1) . The term "borrowing" as used in § 324 refers not only to the typical loan of funds to or sale of debt obligations by a DI, but also to other transactions re- sulting in acquisition of an equity in- terest in consideration for a fixed sum or sums (regardless of the medium of pay- ment) for which payment is completely or partially deferred. For example, an installment purchase (including a long- term lease or charter that is treated, con- sistent with accounting principles gen- erally accepted in the United States, as an installment purchase) would be a bor- rowing that might qualify as long-term foreign borrowing under § 324. See Ex- amples 1,2, and 3 below. The term "borrowing" involves only issuance of debt obligations, not equity securities, by a DI. See Examples 2 and 6 below. An international finance sub- sidiary of a DI (see § 323) is considered the same entity as the DI. If such sub- sidiary issues debentures convertible into stock of the DI, the debentures will be considered debt obligations of the DI; however, if the debentures have detach- able warrants entitling the holder to pur- chase DI's stock, the issue will be considered to be part debt and part equity. (For discussion of the computa- tion of proceeds of long-term foreign borrrowing when debentures are issued with warrants attached, see Examples 5 and 24 below.) For purposes of determining whether a borrowing is from a foreign national, the lender will be considered to be the per- son extending the credit. With respect to issuance of debt obligations, the first public purchasers are generally consid- ered the lenders. Accordingly, sales of debt obligations to underwriters or deal- ers, United States or foreign, in a public offering are irrelevant in determining whether the debt obligations are sold to foreign nationals. Similarly, if a foreign national does not act for its own account, but as agent or fiduciary for the account of another person, the nationality and residence of the person actually extend- ing credit will determine whether the borrowing is from a foreign national. See Example 7 below. Example 1. DI purchases all the voting stock of a French corporation from an un- affiliated foreign national. The purchase price is $1 million, $250,000 of which was paid in cash at the closing, the balance being pay- able (together with interest) in three equal annual installments commencing 1 year from the date of closing. DI has made a transfer of capital of $1 million and a borrowing from a foreign national of $750,000, which will qualify as long-term foreign borrowing if it meets the applicable requirements of § 324. See § B324-4 (i)-(iv). Example 2. DI acquires all the voting equity of a French corporation from foreign shareholders, in exchange for 20,000 shares of DI's common stock at the closing, 10,000 shares of such stock 3 years after the closing, and an indeterminate number of s.hares (based on future earnings of the French corporation) 5 years after the closing. DI has not made a borrowing with respect to the obligation to deliver common stock 3 years and 5 years hence. (The value of the transfer of capital will depend on all the facts and circumstances of the acquisition.) If, how- ever, DI had agreed to deliver $10 million worth of its capital stock 3 years after closing (the actual number of shares to be delivered will depend on their market value at the time) , DI would be deemed to have made a borrowing of $10 million. The obligation would be for a fixed sum, and the medium of payment may be other than cash. Example 3. DI enters into a 10-year equip- ment lease with an unaffiliated foreign na- tional (X). The equipment lease with X is appropriately treated as an installment pur- chase by DI under accounting principles gen- erally accepted in the United States. An appropriate portion of the aggregate rentals should be treated as borrowing from a foreign national by DI, the remainder being allo- cated to interest charges. Example 4. An international finance sub- sidiary of DI sells abroad $20 million face amount of debentures at par. The debentures have a 12 r year maturity and are convertible into common stock of DI after 6 months from date of issue. DI has made a borrowing from a foreign national of $20 million, which will qualify as long-term foreign borrowing if it meets the applicable requirements of § 324. See § B324-^ (i)-(iv). Example 5. An international finance sub- sidiary of DI sells abroad $20 million face amount of debentures at par. The debentures have a 12-year term and have no required sinking fund payments. Each $1,000 deben- ture is sold with a warrant attached for five shares of common stock of DI. The warrants are detachable after 6 months, and are exer- cisable after 12 months from the issue date. DI has made a borrowing from a foreign na- tional of $20 million, less an amount reason- ably allocable to the value of the warrants. Example 6. DI sells abroad 500,000 shares of preferred stock for $50 per share. DI has not made a borrowing for purposes of § 324. Example 7. DI desires to borrow $1 million from a Swiss bank. The bank states that it would not itself lend the funds, but that it can plaoe the loan with a U.S. resident and national who has an account at the Swiss bank. The loan„ if consummated, would not constitute a borrowing from a foreign na- tional within the meaning of § 324(a). The additional requirements for a bor- rowing by a DI from a foreign national to qualify as long-term foreign borrow- ing depend upon whether the borrowing was made (i) prior to January 1, 1968 (the effective date of the Program) ; (ii) from January 1 through June 9, 1968; (iii) from June 10, 1968 through April 30, 1970; or (iv) on or after May 1, 1970. (i) Borrowings made prior to Janu- ary 1, 1968. A borrowing made prior to January 1, 1968, was a long-term foreign borrowing if such borrowing had Purchase of AFN. If an incorpo- rated AFN acquires from an unaffiliated foreign national an interest in a foreign national that becomes an AFN of the parent DI as a result of the acquisition, the full purchase price is treated as a transfer of capital by the acquiring AFN to the DI and as a further transfer of capital by the DI to the acquired AFN. However, if the acquisition is made after December 31, 1967, and the acquired AFN has subsidiaries and/or branches in other scheduled areas that become sep- arate AFNs of the DI as a result of the acquisition, the transfer of capital by the DI should be allocated among the dif- ferent scheduled areas involved in a manner fairly reflecting the respective values of the direct and indirect in- terests acquired. As a general rule, an allocation based on the respective book values of the entities involved is accept- able. The result is the same whether the acquiring AFN pays cash or gives a debt obligation in exchange for the interests acquired. If, however, the consideration for the acquisition is stock of the acquir- ing AFN, no transfer of capital to or from the DI will result. (ii) Sale of AFN. If an incorporated AFN sells an interest in another AFN to an unaffiliated foreign national, there will be a transfer of capital by such other AFN to the DI in an amount equal to the purchase price and a further trans- fer of capital by the DI to the selling AFN in an amount equal to the cost or other basis to the selling AFN of the interest sold. Any capital gain or loss realized by the selling AFN from the sale will be included in determining the earn- ings of the AFN for the period involved. An allocation of the transfer of capital to the DI among different scheduled areas will be required (generally, based on relative book value of the com- ponents divested) if the interest sold was acquired after December 31, 1967, and the AFN in which the interest is sold has subsidiaries and/or branches in different scheduled areas that are sepa- rate AFNs of the DI. The result is the same whether the selling AFN receives cash or a debt obligation of the pur- chaser in exchange for the sale. If, how- ever, consideration for the sale is stock in a foreign national that becomes an AFN as a result of the transaction, no transfer of capital to or from the DI will result. Example 11. During 1969 a wholly owned Schedule B subsidiary (B) of DI purchases from an unaffiliated foreign national, for $1 million in cash, all of the stock of a Schedule C corporation (C). Under §505 (a)(3), the transaction is treated as a REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 44 RULES AND REGULATIONS $1 million transfer of capital from B to DI and a $1 million transfer of capital from DI to C. Accordingly, the transaction reduces by $1 million the net transfer of capital made by DI to Schedule B during 1969 and Increases by an equivalent amount the net transfer of capital made by DI to Schedule C during the same year. If B had paid only $500,000 in cash and gave a 5-year note to the seller for the $500,000 balance of the purchase price, the result would be the same. No transfers of capital will be involved when B subsequently makes payments on the note. The result would also be the same even if DI owned only 51 percent of the Schedule B AFN. Note, however, that if DI owned an Interest of 50 percent or less in the Schedule B AFN, the transaction would not involve any transfer of capital to or from DI, regard- less of the amount of the interest in the Schedule C corporation acquired by the Schedule B subsidiary, since the DI is pre- sumed in this situation to lack control over the transaction. Note also that if the ac- quiring and the acquired corporation were in the same scheduled area, the transaction would effectively "net cut." Example 12. DI has a wholly owned Sched- ule B subsidiary (B) that has a wholly owned Schedule C subsidiary (C). During 1969, B sells all stock of C, that had been purchased for $500,000, to an unaffiliated foreign national for $1 million in cash. Under 1505(a)(3), the transaction is treated as a $1 million transfer of capital from C to DI and a $500,000 transfer of capital from DI to B. The $500,000 profit (measured by historical cost) realized by B will be taken Into account in calculating that subsidiary's 1969 earnings. IX B had received $500,000 in cash and a 5-year note of the purchaser for the $500,- 000 balance of the purchase price, the result would be the same. No transfers of capital will be involved when B subsequently receives payments on the note. The result would be the same even if DI owned only 51 psrcent of the Schedule B AFN. Note, however, that if DI owned an Interest of 50 percent or less in the Schedule B AFN, the transaction would not involve any transfer of capital to and from DI, since the DI is presumed in this situation to lack control over the transaction. Example 13. In 1969, DI's wholly owned Incorporated AFN (C) in Schedule C acquired a 50 percent profits interest in a Joint venture (B) in Schedule B from an unaffiliated foreign national for $1 million cash. During 1969 B earned $100,000 which it remitted to C and the other owners. In 1970, C's interest in B is purchased by the local government for $1,200,000. Assuming no other transac- tions during 1970, DI should report a nega- tive net transfer of capital with respect to B of $1,200,000, a positive net transfer of cap- ital to C of $1 million and reinvested earnings for C of $200,000 (gain on the sale). Example 14. DI has a wholly owned Incor- porated AFN (C) in Schedule C. which has a subsidiary A in Schedule A. During 1970, C sells its interest in A (acquired for $2 mil- lion) to B. a wholly owned Incorporated AFN of DI in Schedule B, for $2 million in cash. By operation of § 505, DI should report a negative transfer of capital from Schedule B of $2 million and a positive transfer of capital to Schedule C of $2 million. Example 15. In 1969, DI's wholly owned In- corporated AFN (A) in Schedule A acquired a 50 percent profits interest in a Joint ven- ture (B) in Schedule B for $1 million, the other 50 percent being held by an unaffiliated foreign national (X). For 1969, DI reported a net transfer of capital of $1 million to Schedule B and a negative net transfer of capital of $1 million to Schedule A. During 1970, DI's wholly owned subsidiary (C) in Schedule C acquires A's Interest in B for $2 million. B earns $400,000 in 1970 and remits $100,000 each to C and X. B's net assets increase by $200,000. Assuming no other transactions during 1970, DI should report a negative transfer of capital from C of $2 mil- lion and reinvested earnings for C of $100,- 000; a net transfer of capital to Schedule B of $100,000; a positive transfer of capital to A of $1 million and reinvested earnings for A of $1 million (gain on the sale of B to C). § B505— 7 Transactions between AFNs not involving transfers of capital. Transfers between AFNs will not in- volve transfers of capital to or from the DI unless the transfer, if actually made by the DI, would be a transfer of capital under § 312. Consequently, the transac- tions described in § 312(c) will not result in transfers of capital when carried out by AFNs. See § B312-18 and 19. (i) Stock for stock transactions and reorganizations. As a general rule, a transfer of capital to or from a DI will not be involved under § 505(a) (3) if (a) an AFN of a DI transfers an interest in a lower-tier AFN and receives in ex- change stock of a foreign corporation that b omes an AFN of the DI as a result of the transaction or if (b) there is a recapitalization, reorganization, merger or consolidation involving one or more AFNs. Although a foreign enterprise may cease to be an AFN of a DI as a result of the transaction, the transaction does not affect the amount of direct investment made by the DI during the base period years in the scheduled area of such for- eign enterprise. Example 16. B, a wholly owned Schedule B subsidiary of DI, transfers to an unaffiliated foreign national all of the stock of a wholly owned Brazilian subsidiary in exchange for aU of the stock of a French corporation. The transaction does not result in any transfer of capital to or from DI. However, as a result of the transaction DI becomes a DI in the French corporation and ceases to be a DI in the Brazilian corporation. (The result would be the same if the other party to the transaction were also an AFN of DI.) Example 17. A wholly owned German sub- sidiary of DI Is reincorporated in the United Kingdom (or, alternatively, merged into a wholly owned United Kingdom subsidiary of the DI). Neither transaction results in any transfer of capital to or from the DI. How- ever, the business of the newly created United Kingdom subsidiary (or the United Kingdom subsidiary after the merger) that is con- ducted in Germany will be a branch of the United Kingdom subsidiary and may, there- fore be a separate unincorporated Schedule C AFN of DI by operation of § 304. (ii) Transfers of certain intangibles. A transfer of property from one AFN to another AFN of the same DI before or after January 1, 1968, in exchange for a debt or equity interest in the transferee AFN does not involve a transfer of capi- tal to or from the DI (regardless of the form of the transfer or the consideration exhanged therefor) if the property transferred consists of patents, copy- rights, trademarks, trade names, trade secrets, technology, proprietary proc- esses, proprietary information, or similar intangibles or any rights or interests therein or applications or contracts re- lating thereto (see § 312(c) (ID). No deduction for amortization or any like charge with respect to such an intan- gible transferred after January 1, 1968, shall be made against earnings in calcu- lating the earnings of the transferee AFN". (iii) Vessel charters. Any charter of a vessel for a period of time made or deemed made by an incorporated AFN to another incorporated AFN of the DI is excluded from treatment as a transfer of capital under § 505(a) (3). This ex- clusion applies to voyage and bareboat charters as well as to time charters. Example 18. During 1969 a wholly owned Panamanian subsidiary (A) of DI, charters one of its ships to C, a wholly owned Ger- man subsidiary of the DI, for a period of 6 months. There is no transfer of capital to or from DI under § 505(a) (3) . (iv) Short-term trade credits between AFNs. Section 505(b) provides, in effect, that the extension or satisfaction of a short-term trade credit between non- Canadian AFNs (see § 1103(c)) of a DI will not result in a transfer of capital to or from the DI, or in any net change in the net assets of an unincorporated AFN extending or receiving such credit for purposes of § 313(b). Section 505(b) ap- plies to trade credits that are extended in the ordinary course of business pur- suant to arm's-length terms and are in fact paid within 12 months after they are extended. Example 19. On September 1, 1969, a wholly owned French subsidiary (C) of DI, sells equipment to A, a Brazilian subsidiary of DI in the ordinary course of business pur- suant to arm's-length terms. The $1 million purchase price is payable in full by March 1, 1970. There i3 no transfer of capital to or from DI. (The result would be the same if the sale of services, rather than the sale of goods, were involved.) If, however, no part of the purchase price is paid by September 1, 1970, there would be a $1 million transfer of capital from C to DI and from DI to A, deemed to have occurred on September 1, 1970, or on such sooner date as it became ap- parent that A would not be able to make payment prior to September 1, 1970. (The result would be the same if the sale of serv- ices, rather than the sale of goods, were involved.) § B505— 8 Transactions between AFNs and their branches in different sched- uled areas. The net transfer of capital by a DI to unincorporated AFNs in any scheduled area during any period will generally equal the DI's share in the aggregate net increase or decrease, during the year, in such AFNs' aggregate net assets (see § 313(b)). This calculation is based on changes in the net assets of all unincor- porated AFNs located in such scheduled area, including those in which DI has an Indirect interest, e.g., a branch of an AFN that is headquartered in another scheduled area. However, § 505(a) (4) provides that a DI is chargeable with a net transfer of capital only to unincor- porated AFNs the immediate parent of which is either the DI or another AFN that is an "affiliate" of the DI as defined in § 903(a). While a DI's share of the change in net assets of a § 903(a) affiliate incorporated AFNs branch is automatically included REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7. 1970 RULES AND REGULATIONS 45 in the DI's net transfer of capital to the scheduled area where the branch is lo- cated, certain changes in branch assets also result in a corresponding transfer of capital from or to the parent AFN. Sec- tion 505(a) (5) and (6) provides that a corresponding transfer of capital from or to the parent occurs when the net in- crease or decrease in branch assets can- not be attributed to earnings or losses of the branch. The same principles apply to transac- tions involving an incorporated AFN that has a less than 100 percent profits interest in a joint venture or a partner- ship, rather than a branch (which is pre- sumably 100 percent-owned) . See § B313- 4(h) , especially Example 8, and § B505-9 below. Example 20. DI has a wholly owned AFN in France (Schedule C), that has a branch In Brazil (Schedule A). DI has no other AFNs. During 1969 the branch has earnings of $50,000 but its net assets increase by $100,000 because of a transfer of $50,000 from the AFN to the branch. This results, under § 313(b), in a $100,000 positive net transfer of capital to Schedule A (DI's share of the net increase in branch assets) and, under § 505(a) (6), in a $50,000 negative net transfer of capital to Schedule C (the amount by which DI's share in the net increase in branch assets ($100,000) exceeded DI's share in the branch's earnings ($50,000)). If DI owned only 60 percent of the French AFN, the result would be a $60,000 positive net transfer of capital to Schedule A (60 percent of $100,000) and a $30,000 negative net transfer of capital to Schedule C (60 percent of $50,000) . If DI owned 50 percent or less of the French AFN, no net transfer of capital would be involved. The following are variations of the facts given above : (a) Positive earnings-decrease in assets. If the branch had 1969 earnings of $50,000 but its net assets decreased by $150,000 be- cause of a remittance of $200,000 to the parent AFN, this would result, under § 313 (b), in a $150,000 negative net transfer of capital to Schedule A (DI's share of the $150,000 net decrease in branch assets) and, under § 505(a) (5), in a $150,000 positive net transfer of capital to Schedule C (DI's share of the $150,000 net decrease in branch assets not attributable to losses) . Moreover, the full amount of branch earnings ($50,000) would be treated as having been distributed to the Schedule C parent and would be de- ducted from dividends paid by the parent to DI (see §B306-6(iii)). If DI owned only 70 percent of the French AFN, the result would be a $105,000 negative net transfer of capital to Schedule A (70 percent of $150,000) and a $105,000 positive net transfer of capi- tal to Schedule C (70 percent of $150,000). Moreover, $35,000 of the earnings of the branch (DI's 70 percent share of the $50,000 branch earnings) would be treated as having been distributed to the Schedule C parent and should be deducted from dividends paid by the parent to DI. If DI owned 50 percent or less of the French AFN, no net transfer of capital would be involved; however, an ap- propriate percentage of the earnings of the branch would still be treated as having been distributed to the Schedule C parent and would be deducted from dividends paid by the parent to DI. (b) Zero earnings-decrease in assets. If th» branch had 1969 earnings of zero and net- assets decreased by $100,000 because of a remittance of $100,000 to the parent AFN, this would result, under 1313(b), to a $100,000 negative net transfer of capital to Schedule A (DI's share of the $100,000 net- decrease in branch assets) and, under § 505(a) (5) , in a $100,000 positive net trans- fer of capital to Schedule C (DI's share of the $100,000 net decrease in branch assets not attributable to losses) . (c) Loss-no change in assets. If the branch incurred a loss of $100,000 during 1969, but there was no change in net assets because of a transfer of $100,000 from the parent AFN, this would result, under § 505(a) (6) , in a $100,000 negative net trans- fer of capital to Schedule C (DI's share of the $100,000 loss). '(d) Loss-increase in assets. If the branch incurred a loss of $100,000 during 1969 but had a $50,000 increase in net assets because of a transfer of $150,000 from the parent AFN, this would result, under § 313(b), in a $50,000 positive net transfer of capital to Schedule A (DI's share of the $50,000 net increase in branch assets) and, under § 505(a) (6) , in a $150,000 negative net trans- fer of capital to Schedule C (DI's share of the $50,000 net increase in net assets plus DI's share of the $100,000 loss) . (e) Decrease in assets smaller than loss. If the branch incurred a loss of $100,000 during 1969 while net assets decreased by only $25,000 because of a transfer of $75,000 from the parent AFN, this would result, un- der § 313(b) , in a $25,000 negative net trans- fer of capital to Schedule A (DI's share of the $25,000 net decrease in branch assets) and, under § 505(a) (6) , in a $75,000 negative net transfer of capital to Schedule C (the amount by which DI's share of the loss ($100,000) exceeds DI's share of the net de- crease in branch assets ($25,000)). (f) Decreas-e in assets greater than loss. If the branch incurred a loss of $100,000 during 1969 while net assets decreased by $250,000 because of a remittance of $150,000 to the parent AFN, this would result, under § 313(b), in a $250,000 negative net transfer of capital to Schedule A (DI's share of the $250,000 net decrease in branch assets) and, under § 505(a) (5), in a $150,000 positive net transfer of capital to Schedule C (DI's share of the $250,000 net decrease in branch assets not attributable to the $100,000 loss). § B505— 9 Miscellaneous transactions. An unincorporated AFN may have two or more immediate parents that are AFNs of the DI. The DI's interest in the unincorporated AFN held through any immediate parent that is not a § 903(a) affiliate of the DI should be excluded in calculating DI's net transfer of capital under § 313(b). Example 21. DI has a wholly owned sub- sidiary (A) in Schedule A and a 50 percent owned subsidiary (C) in Schedule C. A and C each have a 50 percent profits interest in a Joint venture (B) in Schedule B. During 1970 B earns $1 million, and its net assets increase by $1 million. DI's net transfer of capital under § 313(b) with respect to B Is $500,000. DI's share of the increase in the assets of B attributable to C is excluded be- cause C is not a § 903(a) affiliate of DI. If C were 60 percent owned by the DI, DI's share of B's increase in assets for 1970 would be $800,000: A's share (50% X 1,000.000) X 100%, plus C's share (50% X 1,000,000) X 60%. During 1971, C (60% owned) makes a $1 million loan to B. For purposes of § 313(1)) B has a net increase in its assets of $1 minion. C's share of such increase is $1 million, and A's share is zero. See Example 8 in § B3I3— 4. DI's share of the increase in B's assets is $600,000 (60% of C's share). For 1971 DI should report a net transfer of capital under 8 313(b) to Schedule B of $600,000 and a negative net transfer of capital to Schedule C under §313 (a) of $600,000. Example 22. DI has a wholly owned Incor- porated AFN (C) in Schedule C and a wholly owned incorporated AFN (A) in Schedule A. A and C, respectively, have a 40 percent and a 60 percent profits Interest in a joint ven- ture (B) in Schedule B. During 1970 DI lends $100,000 to B. Under § 505(a) (1) and(2),DI is deemed to have made a $40,000 transfer of capital to A (40 percent of $100,000) and a $60,000 transfer of capital to C (60 percent of $100,000). B has a net increase in assets of $100,000, which is not attributable to earnings; therefore, under § 505(a) (6), A is deemed to have made a transfer of capital to DI of $40,000, and C is deemed to have made a transfer of capital to DI of $60,000. Consequently, DI's net transfer of capital to each scheduled area for 1970 is as follows: Schedule A, zero; Schedule B, $100,000; Schedule C, zero. Example 23. Same facts as in Example 22, except that A is 75 percent owned by DI and C is 50 percent owned. In this case, the loan from DI to B would constitute a transfer of capital under § 505(a) (1) and (2) to A of $40,000 and to C of $60,000 as in Example 22. However, since C is not an affiliate of DI, DI's share of B's increase in assets is only $30,000 (A's 40 percent share X 75 percent). Under § 505(a) (6), A is deemed to have made a transfer of capital to DI of $30,000. C, not being an affiliate, is not deemed to have made a transfer of capital to DI under § 505(a) (6) . Therefore, DI's net transfer of capital to each scheduled area is as follows: Schedule A, $10,000; Schedule B, $30,000; Schedule C, $60,000. If A and C were each 50 percent owned by DI, DI's loan to B would still be deemed made to A and C under § 505(a) (1) and (2) In accordance with the percentage Interests of A and C in B. But since neither A or C is an affiliate of DI, DI would have no share in B*s increase in assets (see § 505(a) (4)) and no transfers would be deemed made un- der 5 505(a)(6). Consequently, DI's net transfer of capital to each scheduled area would be as follows: Schedule A, $40,000; Schedule B, zero; Schedule C, $60,000. B506 — Incremental Earnings Allowable § B506-1 Introduction. In addition to the § 503, § 504, or § 507 allowable which is elected under § 502, an incremental earnings allowable is pro- vided by § 506. The incremental earnings allowable is a separate allowable that au- thorizes the making of positive direct in- vestment in excess of that permitted by § 503, § 504, or § 507, whichever may have been elected by the DI. The § 506 incre- mental earnings allowable is available to DIs for use in 1970 and succeeding years. § B506— 2 Summary. The incremental earnings allowable, if any, available to a DI will be the amount by which 40 percent of incre- mental earnings (defined in § 508(a) (3) ) for the current year exceeds the greatest amount of positive direct investment au- thorized in all scheduled areas pursuant to § 503, § 504(a), or § 504(b). For pur- poses of this calculation, it is immaterial whether the DI has elected to be gov- erned by § 503. § 504, or § 507 for the current year. The additional positive direct invest- ment authorized by § 506 may be made in any or all scheduled areas. REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 46 Unused § 506 allowables may be car- ried forward to succeeding years. § B506— 3 Calculation of incremental earnings allowable. The following steps are required to calculate the incremental earnings allowable : Compute current aggregate annual earn- ings (annual earnings, as defined in § 504(b) (4) ) of all incorporated and unicorporated APNs for all scheduled areas combined, ex- cluding Canada; Compute base period aggregate annual earnings; i.e., 50 percent of the sum of ag- gregate annual earnings for the years 1966 and 1967 (but not less than zero) ; and Determine the current year's incremental earnings, if any, by subtracting base period aggregate annual earnings from aggregate annual earnings for the year involved. The incremental earnings allowable is the amount by which 40 percent of the DI's incremental earnings exceeds the greatest amount of positive direct in- vestment authorized to be made by the DI in all scheduled areas for the current year under § 503 or § 504 (excluding any carryforward of allowables from prior years, and without regard to any reduc- tion under § 1003, authorization or com- pliance action, or to the § 502 election actually made) . The following examples illustrate cal- culation of the § 506 allowable: Example 1. DI has an AFN (A) in Pakistan. In 1966 A had losses of $100,000 and in 1967 earnings of $500,000. DI's base period aggre- gate annual earnings under § 506(a) (2) is $200,000 ($500,000 — $100,000 divided by 2). Assume that DI's historical and earnings allowables under §504 (a) and (b) are each less than $1 million. In 1970 A has earnings of $3,400,000. DI's incremental earnings allowable under § 506 in 1970 is $280,000, calculated as fol- lows (000 omitted) : 1970 aggregate annual earnings $3,400 Deduct: Base period aggregate an- nual earnings —200 Incremental earnings 3,200 40 percent of incremental earnings-- 1,280 Deduct: Largest of available allow- ables (i.e., §503) — 1,000 Incremental earnings allowa- ble 280 Example 2. DI has six APNs: Two incor- porated In Schedule A, two incorporated in Schedule B and two branches in Schedule C. In 1966 the APNs had aggregate annual losses of $200,000 and in 1967 aggregate an- nual earnings of $100,000. DI's base period aggregate annual earnings are, therefore, zero. Assume that DI's historical allowables in Schedules A and B are, respectively, $300,- 000 and $400,000. The Schedule C historical allowable is zero. Accordingly, DI's § 504(a) allowables for all scheduled areas are $700,000. In 1969 the AFNs had annual earnings of $1,500,000 in Schedule A, $1,200,000 in Sched- ule B, and $1 million in Schedule C. There- fore, DI's 30 percent earnings allowable for 1970 is $450,000 in Schedule A, $360,000 in Schedule B and $300,000 in Schedule C; a total of $1,110,000 worldwide. In 1970 the AFNs have aggregate annual earnings of $4,000,000. RULES AND REGULATIONS DI's Incremental earnings allowable for 1970 is $490,000, computed as follows (000 omitted) : 1970 aggregate annual earnings $4, 000 Deduct: Base period aggregate an- nual earnings Incremental earnings 4,000 40% of incremental earnings 1,600 Deduct: Largest of available allow- ables (i.e., § 504(b)) . -1,100 Incremental earnings allow- able 490 § B506-4 Application of the § 506 allowable. Unlike the allowables provided in §§ 504 and 507, which are schedular, the incremental earnings allowable applies on a worldwide basis. In other words, the additional direct investment authorized by § 506 can be made entirely in one scheduled area, or can be divided among two or more scheduled areas. Any unused § 506 allowable may be carried forward to subsequent years for use in any one or more scheduled areas, without regard to the election made under § 502. Section 506(b) applies to DIs that elect § 503. Positive direct investment is au- thorized in excess of $1 million to the extent of the incremental earnings al- lowable. Since § 506 may be used on a worldwide basis, DIs that elect § 503 may treat the incremental earnings allowable as an addition to the $1 million minimum allowable. Section 506(c) applies to DIs electing the schedular allowables of §§ 504 and 507. In such cases, the incremental earn- ings allowable may be used to. authorize additional positive direct investment in a given scheduled area or distributed among two or all of the scheduled areas. In calculating positive direct investment made under § 506 in Schedule C, a DI electing § 504 must disregard total losses of all incorporated Schedule C AFNs in accordance with § 504(e) . Example 3. In 1970 DI elects to be governed by § 504(a), and has historical allowables of $5 million, $6 million, and $4 million in Schedules A, B, and C, respectively. DI also has an incremental earnings allowable of $1 million. DI makes positive direct investment of $7,500,000 in Schedule A, $4 million in Sched- ule B and $4,500,000 in Schedule C, all of which is authorized. In Schedule A, $5 million is authorized by § 504(a), $2 million of the Schedule B historical allowable is carried "downstream" pursuant to § 504(d), and $500,000 of the § 506 allowable is used. In Schedule C, $4 million is authorized by § 504 and the remaining $500,000 is authorized by § 506. Example 4. During 1970 DI elects § 504 with an allowable in Schedule C of zero. DI also has a § 506 incremental earnings allowable of $200,000. During 1970 DI's Schedule C APNs have total losses of $100,000. If DI desires to use the incremental earnings allowable in Schedule C, DI may make a positive net transfer of capital not in excess of $200,000; i.e., the losses will not be an offset for purposes of computing positive di- rect investment made in Schedule C under § 506. See § 506(c). § B506-5 Carryforward of the § 506 allowable. Unused § 506 allowables may be carried forward to subsequent years for use in any scheduled area, even though DI may have elected § 503 or § 507, which do not authorize carryforwards and elimi- nate §§ 504 and 1302 carryforwards. Example 5. DI elects to be governed by § 503 in 1970 and has an incremental earn- ings allowable of $200,000. During 1970, DI makes positive direct investment worldwide of $1,100,000. DI has a § 506 carryforward of $100,000. Example 6. In 1970 DI has historical allow- ables of $7 million in Schedule A and $7 million In Schedule C. DI also has a carry- forward allowable of $1 million in Schedule A pursuant to 5 504(d)(1) and an incre- mental earnings allowable under § 506 of $1 million. During 1970, DI makes positive direct investment of $8 million in Schedule A and $7 million in Schedule C. DI will be permitted to use the $1 million incremental earnings allowable in any sched- uled area in subsequent years. § B506— 6 Miscellaneous. Repayment charges incurred under § 1003 in connection with repayment of certain borrowings will, starting in 1970, reduce the § 506 incremental earnings allowable to the extent that such re- payments exceed the DI's § 503, § 504, or §507 allowables. See § 1003(c)(2). B507 — Alternative Minimum and Schedule A Supplemental Allow- able § B507-1 Introduction. Commencing in 1970, a DI may elect the § 507 alternative minimum and Schedule A supplemental allowable. Section 507 provides, in effect, that a DI may make positive direct investment during 1970 of $1 million on a modified worldwide basis and an additional $4 mil- lion in Schedule A. The § 507 allowable comprises a $4 million allowable for Schedule A and a $1 million allowable for Schedules B and C combined (some- times referred to as "Schedules ByC"). See § 507(a) (1) and (2). To the ex- tent not used in Schedules B/C, the $1 million allowable under § 507(a)(1) may be used in Schedule A in addi- tion to the $4 million authorized exclu- sively for Schedule A under § 507(a) (2). See § 507(b) and Examples 2, 3, and 4 below. Direct investment in Schedules B and C is to be computed in the same manner as worldwide direct investment under § 503. See Example 1 below. Thus, § 507 is basically a schedular allowable similar to § 504 but consists of two sched- uled areas rather than three. It should be noted that while § 505 interschedular transfers from Schedule B to Schedule C will net out under § 507, transfers from Schedule A to Schedule B or C will not net out, and the resulting positive di- rect investment in Schedules B/C must be authorized by the $1 million allow- able under § 507(a) (1). See Examples 5 and 6 below. On the other hand, § 507 is similar to § 503 in the following respects: (i) Unused allowables under § 507 may not be carried forward to succeeding years, and carryforwards from prior years under §§ 504 and 1302 are lost when § 507 is elected (see § 507(c)); (ii) A DI that elects to be governed by § 507 is not subject to the prohibitions of § 203(d)(1); and REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 47 (ill) The use of § 507 by members of an associated group and consenting own- ers of a principal DI is governed by the limitations of amended §§905 and 906. § B507-2 Application of the § 507 allowable. Under § 507, direct investment in Schedule A is calculated separately from direct investment in Schedules B and C. For purposes of § 507(a)(1), direct in- vestment in Schedules B and C is aggre- gated. Example 1. DI has a wholly owned subsid- iary (C) in Schedule C, which has a wholly owned subsidiary (A) in Schedule A, and DI has a wholly owned subsidiary (B) in Sched- ule B. During 1970 the following occurs: DI makes a transfer of capital of $4 million to A. A earns $200,000 and pays dividends of $200,000 to C. B makes a transfer of capital of $500,000 to DI. DI makes a transfer of capital of $1,300,000 to C. DI correctly re- ports positive direct investment in Schedule A of $4 million and in Schedules B and C of $1 miUion, all of which is authorized by §507, computed as follows ($000 omitted): Scheduled area Scheduled area A b e B/C ag- gregate Net transfer of capital. . Keinvested earnings „ 4,000 (500). 1,300 200 800 200 Positive direct invest- ment 4,000 (500) 1, 500 1,000 Example 2. During 1970 DI acquires an AFN in Schedule A from an unaffiliated for- eign national for $5 million and makes no direct investment in Schedule B or C. The $5 million positive direct investment is au- thorized by § 507(a) (2) and (b). Example 3. During 1970 DI's AFN (C) in Schedule C makes a transfer of capital of $500,000 to DI, and DI's Schedule B AFN (B) makes a transfer of capital of $1,500,000 to DI. DI has negative direct investment in Schedules B/C of $2 million. Therefore, un- der § 507(a) (2) and (b) , DI may make $7 million of positive direct investment in Schedule A during 1970. Example 4. The following table illustrates the "downstream" use of the basic $1 mil- lion allowable pursuant to § 507(b) ($000 omitted) : Then direct invest- ment authorized If direct investment by §507 (a)(2) made in Sched- and (b) in Sched- ules B/C is: uleAwlllbe: 500 4,500 5,000 (2000) 7,000 Example 5. During 1970 DI makes a trans- fer of capital of $5 million to Its Schedule A incorporated AFN (A). A, in turn, lends $5 million to DI's Schedule C Incorporated AFN (C). By operation of § 505(a) (3), DI has made positive direct investment in Schedule A of zero and in Schedule C of $5 million. Only $1 million of the Schedule C investment is authorized by § 507, and DI is otit of compliance to the extent of $4 million in Schedule C. Example 6. DI has a 60 percent-owned sub- sidiary (C) in Schedule C. C has a branch (A) in Schedule A. DI transfers $4 million to A. A has no earnings, and its net assets increase by $4 million. Assuming no other transac- tions, DI has made positive direct invest- ment of $2,400,000 in Schedule A and $1,600,000 in Schedule C, computed as fol- lows ($000 omitted) : Transfers of capital: § 505(a) (1) and (2) 4,000 § 505(a) (6) _ - -- (2,400) Net transfers of capital: § 313(b) 2„400 - § 313(a) - - - 1,600 Positive direct investment.. 2,400 1,600 DI is out of compliance under § 507 to the extent of $600,000 in Schedule C. § B507-3 Related provisions. DIs electing § 507 in 1970 should see § 306(e) (3), discussed in § B306-7, if they contemplate repayment or realloca- tion of borrowings deducted from § 503 worldwide positive direct investment un- der § 306(e) in 1969. The use of § 507 by members of an associated group and consenting owners of a principal DI is limited. See §§ 905- (b)(2) (ii) and (iii) and 906(b) (3) (Hi) and (iv). Reduction under § 1003 of the $4 mil- lion Schedule A supplemental allowable provided for Hi § 507(a) (2) is governed by § 1003(c) (5) and (d) . (See § B1003-1 (Hi) .) As provided by § 502 (c) and (d) , a DI may not elect § 503 in one year, start- ing in 1970, and § 507 in the next year, or vice versa, without obtaining prior written permission from OFDI. If two DIs combine, by merger or otherwise, during the year, the surviving DI is entitled to only one § 507 allowable for such year. DIs that elect § 507 may also use the § 506 incremental earnings allowable, but not the foreign air transport earnings allowable of § 1302. B801 — Applications for Specific Au- thorizations or Exemptions or for Interpretive Opinions § B801-1 Introduction. Section 201 prohibits DIs from making positive direct investment in AFNs in excess of amounts generally authorized by the regulations, or as may be spe- cifically authorized by OFDI. Section 801 provides that DIs may file applications for specific authorizations to effect posi- tive direct investment otherwise pro- hibited and specific exemptions from complying with particular requirements of the regulations. In addition, DIs may file requests for interpretive opinions concerning particular factual situations, including those involving the possibility that a DI may have to apply for a spe- cific authorization or exemption. § BOO 1-2 Procedures. Applications for specific authorizations or exemptions and requests for interpre- tive opinions must be submitted in writ- ing and must comply with instructions contained in the Revised Instructions for Submitting Applications for Specific Authorizations or Exemptions or for In- terpretive Opinions (the "Instructions"), issued by OFDI on September 11, 1970 (attached as the Appendix hereto), as they may be amended and supplemented from time to time. If a DI is uncertain whether it may or may not require a specific authorization or exemption concerning a particular transaction, a combined request for an interpretive opinion or, in the alterna- tive, a specific authorization or exemp- tion may be submitted. § B801— 3 Particular authorizations or exemptions. Note that Part I of the Instructions sets forth particular requirements con- cerning applications for specific author- izations or exemptions regarding (a) merchandise export credit extended by a DI to its AFNs (paragraph C), reinvested earnings of AFNs (paragraph D), (c) foreign equity financing of direct investment (paragraph E), (d) the re- quirement to repatriate to the United States available proceeds of long-term foreign borrowing (paragraph F), (e) triangular or parallel financing arrange- ments (paragraph G), (f) an increase in the amount of liquid foreign balances that a DI can hold (paragraph H), (g) upstreaming to Schedule C of § 504(b) earnings allowable (paragraph I), and (h) capitalized exploration expenditures (paragraph J). In the 1969 General Bulletin, specific authorizations in connection with over- seas finance subsidiaries of DIs were discussed in this section of the Bulletin. A new Subpart N, effective as of Jan- uary 1, 1970, now provides for such overseas finance subsidiaries, so that DIs no longer need obtain a specific authori- zation to utilize such AFNs in the man- ner set forth in Subpart N. B900 — Subpart I (§§ 901-907) § B900-1 Introduction. Subpart I of the regulations (§§ 901- 907) deals with direct investment by persons within the United States who are related, affiliated or associated with other persons within the United States. These relationships are described as af- filiated groups (§903), family groups (§904), associated groups (§905), and ownership of direct investors (§906). Section 907 provides rules for reporting direct investment transactions involving such groups. Sections 901 and 902 de- fine the terms "direct interests" and "in- direct interests," which are significant in determining: Existence of a DI-AFN relationship under §§ 304 and 305; A DI's share in reinvested earnings of an incorporated AFN under § 306(b) ; Whether an AFN is an "affiliate" of a DI, so that transfers made by or to the AFN should be attributed to the DI under § 505; Existence of an affiliated or associated group under §§ 903 and 905; and Availability and consequences of an elec- tion under § 906(b) (1). Members of an affiliated group or a family group are treated as a single en- tity for reporting and compliance pur- poses under the regulations. An affiliated group consists of a U.S. person and all of such person's U.S. affiliates (see §903). A family group consists of all family members residing in the same household (see § 904) . An affiliated or family group files a consolidated Form FDI-101 (Base Period Report), FDI-102 (Cumulative REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 48 RULES AND REGULATIONS Quarterly Report), and FDI-102F (An- nual Report) ; members of the group do not file reports individually (see § 907(d)). Two or more U.S. persons acting in concert to own or acquire an aggregate 10 percent or greater interest in a for- eign national constitute an associated group. Each member of an associated group is treated as a separate DI in the APN acquired (the "group AFN") , and is required to report individually unless certain requirements pertaining to con- solidated reporting are met (see §§ 905 (b) (3) and 907(c) (2)). Direct investment transactions of a DI normally will not be attributed to any other person merely because such other person owns an interest in the DI. How- ever, an option under § 906(b)(1) is available to direct owners of a DI, whereby each such owner may elect to be put in the position of the DI as to direct investment, allowables and for- eign balances, in accordance with such owner's proportionate interest in the DI. § B901— 1 Definition of direct interest. A direct interest in a corporation, part- nership, joint venture, trust or other en- tity is denned in § 901 as an interest that is not owned through an intervening person or chain of persons. (i) Direct interest in a corporation. The amount of a direct interest in a cor- poration is determined by the percentage held of total combined voting power (represented by all outstanding voting securities of the corporation). Voting power means the power to vote presently in an election of directors of the corpo- ration or, if the corporation does not have directors, in the election or appoint- ment of persons performing management control functions. Treasury shares and shares reserved for issuance upon the exercise of options, warrants, conversion or other similar rights, and shares owned by a wholly owned subsidiary, are not deemed outstanding for purposes of de- termining the magnitude of a direct interest. Example 1. As of January 1, 1969, a cor- poration (X) has 100,000 outstanding shares of capital stock, 60,000 of which are class "A" common, 20,000 are class "B" common, and 20,000 are preferred. In the election of directors, each class A carries three votes and each class B share carries one vote. Holders of preferred stock are entitled to vote on ma- jor matters such as mergers, consolidations, etc., or amendments to the certificate of in- corporation affecting the preferred stock; they are not entitled to vote in the election of directors unless four quarterly dividend payments are in arrears. Y, an individual, owns 8,000 shares of class A common stock, 6,000 shares of class B common stock and 500 shares of preferred stock. No dividends on the preferred stock are In arrears as of January 1, 1969. Y's direct interest in X as of January 1, 1969, is 15 percent, since Y owns 15 percent of the total combined voting power of X (30,000 of a total 200,000 votes). Beneficial ownership of voting stock is ordinarily the test of interest in a cor- poration for determining whether one is a DI, but ownership of such stock is not necessarily determinative of a DI's share in earnings of an incorporated AFN for purposes of § 306 because a corporation may have two classes of stock outstand- ing that share equally in earnings but do not have equal voting rights. Exam- ples in this Bulletin involving incorpo- rated AFN's are based on the assumption that the DI's voting interest and interest in earnings of the AFN are coextensive, (ii) Direct interest in unincorporated business activities. The amount of a di- rect interest in an unincorporated enter- prise, such as a partnership or joint ven- ture, is usually determined by the per- centage share of profits to which one is entitled. If one is entitled to a fixed amount rather than a percentage of profits, or the amount is for any reason variable, the direct interest normally should be calculated by reference to the portion of profits actually distributed or distributable at the close of the most re- cently ended annual accounting period of the organization, assuming there was no change in the interest since that time. If neither of the foregoing rules appro- priately reflects the direct interest in an unincorporated entity, the amount of di- rect interest should be calculated by whatever method will produce a reason- able result. Example 2. On January 1, 1969, P, a part- nership, has three partners (A, B, and C). Under the partnership agreement, A is en- titled to the first $100,000 of distributed profits, and if there are additional profits, he is entitled to receive 5 percent of all such additional profits. B is entitled to 50 percent of profits after the first $100,000 up to $500,- 000 of total profits and to 35 percent of all profits over $500,000. C is entitled to 45 per- cent of profits after the first $100,000 up to $500,000 and 60 percent of all profits over $500,000. Between January 1 and December 31, 1969, P distributed $1 million to the part- ners. A received $145,000, B received $375,000, and C received $480,000. As of January 1, 1970, A's interest in the partnership is 14.5 percent, B's interest is 37.5 percent, and C's interest is 48 percent. The result would be the same if no distri- bution were made but the profits were re- tained and added to the capital accounts of the partners in the same proportion. Example 3. P and Q, two U.S. corporations, enter into a joint venture agreement for the purpose of constructing and owning an apartment house in Rome. The land on which the building is to.be constructed is owned by R, an Italian national, who leases it to P and Q for a rental equal to 20 percent of the annual net rental received by P and Q from the tenants of the building. P and Q are to share equally the remaining 80 percent of net rentals received. The apartment house is a-n APN of P and Q, and each has a 50 percent direct interest in the AFN. If R were a person within the United States, the result would be the same. In addi- tion, the real estate would be an AFN of R in which R has a 100 percent direct interest. If, however, R were not only a person within the United States but a party to the joint venture agreement, P, Q, and R would be members of an associated group (see § 905). The land, and building would be an AFN of P, of Q, and of R, in which P and Q each have a 40 percent interest and in which R has a 20 percent interest. If Z, an Italian corporation, becomes a member of the construction joint venture and will share equally with P and Q net rent- als of the apartment house after R has re- ceived his share, the apartment house would be an AFN of P and of Q, and P and Q each would have a 33 y 3 percent direct interest in that AFN. § B902— 1 Definition of indirect interest. An indirect interest in a corporation, partnership, joint venture, trust or other entity is an interest owned through an intervening person or chain of persons. The amount of an indirect interest is calculated by multiplying together the direct interests of each person in the chain. Example 4. DI owns 50 percent of outstand- ing voting stock of P, a U.S. corporation. P owns 70 percent of outstanding voting stock of C, a French corporation, while C owns 50 percent of outstanding voting stock of B, a United Kingdom corporation. DI has a 50 percent direct interest in P, a 35 percent indirect interest in C (50 percent X 70 percent) , and a 17.5 percent indirect interest in B (35 percent of C's 50 percent interest). Example 5. DI has a 17.5 percent interest in B, a United Kingdom corporation. B has a manufacturing branch in Brazil (A) and is entitled to 80 percent of the profits of C, a partnership organized under the laws of Germany. DI has a 17.5 percent indirect in- terest in A (17.5 percent X 100 percent) and a 14 percent indirect interest in C (17.5 per- cent x 80 percent). § B903-1 Definition of affiliate. As defined in § 903(a) , an "affiliate" of a person within the United States is any other person in which the aggregate of direct interests (defined in § 901) owned by the former person and its affiliates ex- ceeds 50 percent. An "affiliate" may be a U.S. person or a foreign national. Example 6. X is a U.S. corporation. X has a 51 percent direct interest in corporation Y. Y is an affiliate of X. X has a 30 percent direct interest in corporation Z, and Y has a 25 percent direct interest in Z. Z is an affiliate of X, since X and Y (affiliate of X) together have more than 50 percent direct interest in Z. The location of Y and Z is immaterial. Y has a 50 percent direct interest in corpora- tion A. A is not an affiliate of X. Example 7. An individual resident and citi- zen of the United States (P) directly owns 51 percent of outstanding voting stock of cor- poration A, 10 percent of voting stock of corporation C, and all voting stock of cor- poration Y. Corporation A directly owns 30 percent of outstanding voting stock of cor- poration B, and corporation B directly owns 45 percent of outstanding voting stock of corporation C. Corporation Y directly owns 60 percent of outstanding voting stock of corporation Z, and corporation Z directly owns 40 percent of outstanding voting stock of corporation B. All corporations are affili- ates of P. (i) Consequences of being an affiliate. A U.S. person and all U.S. affiliates con- stitute an "affiliated group" (see § 903 (b)). When a U.S. person has an AFN that is an "affiliate" under § 903(a), transactions between the affiliate AFN and any other AFN of the U.S. person are subject to § 505. (ii) Definition of affiliated group. As defined in § 903(b), an "affiliated group" is a person within the United States and all such person's "affiliates" who are persons within the United States. Example 8. P is an individual resident and citizen of the United States. P has a 60 per- cent direct interest in X, a U.S. corporation. X has a 60 percent Interest in C, a French corporation. X and C are affiliates of P. P and X are an affiliated group. C Is not a member REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 49 of the affiliated group, because C is not a person within the United States. (iii) Treatment of members of an affil- iated group as a single person. Except for purposes of an election under § 906 (b) (1) , all members of an affiliated group are treated as a single person (see § 903 (o> ) . Consequently, the foreign balances, direct investment transactions and al- lowables of each member are attributed to the group. The group files a single report for each period for which a report is required, aggregating reportable items of all members of the group (see § 907 (d) ) . In addition, the group, as a whole, makes one election of allowables under § 502. Example 9. Since 1963 X, a U.S. corpora- tion, has owned 51 percent of outstanding stock of another U.S. corporation Y. X and Y are members of an affiliated group, under § 903(b). Since 1963 X has had a wholly owned subsidiary (B) in Schedule B and Y has had a 10-percent-owned subsidiary (A) in Schedule A. B is X's sole APN and A is Y's sole AFN. During 1965-66 X made positive direct investment of $1 million in Schedule B and lent $300,000 to A. Y made positive direct investment in Schedule A of $1,300,- 000. X and Y, as an affiliated group, filed a single Form FDI-101 showing the following § 504(a) historical allowables (000 omitted) : Schedule A: Positive direct investment for 1965- 66 ($1,300 plus $300) $1,600 § 504(a) allowable ($1,600x50% X110%) 880 Schedule B: Positive direct investment for. 1965- 66 1,000 § 504(a) allowable ($1,000x50% X65%) 325 In 1969, X and Y elect the historical allow- able of §504 (a) and (c). X and Y make Dositive direct investment in Schedules A jnd B in an amount aggregating the amounts authorized pursuant to the foregoing calcu- lations. Unused allowables will be available for carryforward or carryover under § 504 by the affiliated group. Positive direct investment made during the year by X and Y will be reported on a single Form FDI-102 and Form FDI-102F. Example 10, A, B, C, and D constitute an affiliated group. During 1965 and 1966, aver- age end-of-month liquid foreign balances subject to § 203(c) held by each member of the group were as follows: A — $100,000; B — $50,000; C — $25,000; and D— none. The Form FDI — 101 filed by the group should show an average end-of-month liquid foreign balance of $175,000 (the sum of the monthly 1965-66 averages of each member of the group) . An affiliated group may itself be a member of an "associated group", as denned in § 905, if any member of the affiliated group acts in concert with another U.S. person (not a member of the same affiliated group) in acquiring or owning an interest in a foreign national Example 11. X is a member of an affiliated group. X enters into an agreement with an unrelated U.S. corporation, Y, pursuant to which X and Y each acquire 5 percent of the outstanding voting stock of C, a Nether- lands corporation, from an unrelated foreign national. C thereby becomes an AFN both of the affiliated group and of Y. § B904— 1 Definition of family group. A "family group" is defined in § 904 as an individual within the United States, his spouse (unless legally separated) , and all relatives of such individual or his spouse residing with such individual. As with an affiliated group, all members of a family group are deemed a single per- son within the United States and file one report under § 602 aggregating all foreign balances, direct investment transactions and other reportable items attributable to each member of the group. Members of a family group cannot elect to report separately (see § B907-l(iv) ) . Example 12. H, a U.S. citizen and resident, lives in New York City with his wife (W) and two teenage daughters (P and Q) . H and W also have two sons (R and S). R is 20 years of age, unmarried, attends undergrad- uate college in California, and is supported by H and W; S is 28 years of age, married, with a child of his own, is self supporting, and maintains his own home. W's grand- father (G) resides with H and W. H, R, and S each own 5 percent of outstanding voting stock of a French corporation (C). W who is wealthy in her own right, is a joint owner with her grandfather, G, of a sub- stantial parcel of commercial real property (K) in the United Kingdom. H, W, P, Q, R, and G are members of a family group and X and K are AFNs of the group. S is not a member of the family group. The family group should file a single report under § 602 for each reporting period, aggregating the direct investment transactions during the relevant period between each member of the group and X and K. A family group may itself be a member of an affiliated group as defined in § 903, or of an associated group as defined in § 905. Example 13. Same facts as in Example 12, except that H owns 100 percent of outstand- ing voting stock of a U.S. corporation (U) , and H and W each own 30 percent of out- standing voting stock of another U.S. cor- poration (V). The family group (i.e., H, W, P, Q, R, and G) , together with U and V, constitute an affiliated group and are sub- ject to the rules governing reporting and other obligations of affiliated groups. Examle 14. Same facts as in Example 12. In 1969, H, a son(S), and T, an unre- lated U.S. person, enter into an agreement pursuant to which each purchases 4 percent of outstanding voting stock of a Japanese corporation (J) from an unrelated foreign national for $100,000 in cash, or a total of $300,000. The family group together with S & T, are an associated group under § 905(a). J becomes an AFN of the family group as well as of S and of T, and each has made a $100,000 transfer of capital to J (Schedule B). Example 15. A U.S. citizen and resident (X) owns all outstanding voting stock of a French corporation (C). In 1967, X estab- lishes an inter vivos trust under New York law and contributes all stock of C to the trust. The trust beneficiaries are X's three minor children, all of whom reside with X. X and a domestic bank are cotrustees of the trust and X expressly retains the right to revoke or amend the trust without consent of the trust beneficiaries. No associated group is involved in this situation. However, X and his children are members of a family group, and the family group and the trust are members of an affiliated group. C is an AFN of the affiliated group. § B905— 1 Definition of associated group. An "associated group" is defined in § 905(a) as two or more persons within the United States, including individuals, legal entities, affiliated groups or family groups, if: (a) Such persons act in con- cert, pursuant to an express or implied agreement or understanding, to own or acquire interests in the same corporation or partnership organized under the laws of a foreign country or in the same busi- ness venture conducted within a foreign country; (b) the interests in the foreign enterprise owned or acquired are not owned or acquired through a corpora- tion, partnership (other than a joint venture) or trust within the United States, whether or not such corporation, partnership, or trust is organized or cre- ated for the purpose of owning or ac- quiring the interests; and (c) the ag- gregate interests in the foreign enter- prise owned or acquired would, if owned or acquired by one U.S. person, cause such person to be a DI. A person owning a direct or indirect interest in a U.S. corporation or partner- ship is not a member of an associated group merely because the U.S. corpora- tion or partnership directly owns an in- terest in a foreign enterprise. Example 16. In 1968, three U.S. citizens and residents (A, B, and X) enter into an agree- ment pursuant to which they form and capi- talize a Delaware corporation (D) and D pur- chases all outstanding voting stock of a French corporation (C) from an unrelated foreign national (N), for $300,000 in cash. A, B, and X each acquire 33 y 3 percent of the voting stock of D. A, B, and X are not mem- bers of an associated group although, as a result of the purchase, C will become an AFN of each of A, B, X, and D. Unless an election under § 906(b)(1) is made with respect to D, the transfer of capital to C (Schedule C) , resulting from piirchase of C's stock, as well as all subsequent direct investment trans- actions between D and C, will be charged to and reported by D alone (see § B907-l(iii) ). Example 17. Same facts as in Example 16. except that A, B, and X do not organize D. but enter into an agreement pursuant to which each of them directly acquires 8 per- cent of outstanding voting stock of C from N for $100,000 in cash, or a total of $300,000. A, B, and X are members of an associated group and each will be charged with a $100,000 transfer of capital to C (Schedule C) . Moreover, unless A, B, and X exercise the election provided in § 907(c) (2) to report as a group, A, B, and X will each file separate Forms FDI-102 and FDI-102F. Example 18. In 1969, three U.S. corpora- tions (A, B, and C) enter into a joint venture agreement for the purpose of developing and exploiting an oil concession in Iran. The agreement is made in New York and provides that it is to be governed by New York law. Under the pertinent concession agreement, the Iranian government is entitled to 50 per- cent of all oil produced, while A, B, and C are to share the remaining 50 percent. A, B, and C are members of an associated group; the joint venture in Iran is an AFN of each. (i) Acting in concert pursuant to an agreement or understanding. An associ- ated group exists only if two or more persons within the United States act in concert pursuant to an agreement or un- derstanding. The agreement may be oral REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7. 1970 50 RULES AND REGULATIONS or written, and an agreement may be implied from the surrounding facts and circumstances even when no express agreement is involved. The most common examples of an express agreement are a joint venture or stockholders' agreements with respect to the stock and manage- ment of the foreign enterprise involved. The mere signature, adherence to or ac- ceptance of the articles of incorporation or bylaws of a foreign corporation will not, of themselves, be considered an ex- press or implied agreement or under- standing to act in concert within the meaning of § 905(a). The result may be different, however, if the articles or by- laws contain provisions ordinarily con- tained in a stockholders' agreement. Similarly, the purchase of stock of a foreign corporation by U.S. underwriters and dealers or U.S. investors in connec- tion with a bona fide public offering, and the execution and performance of cus- tomary agreements in connection with such offering, will not, of themselves, be considered such an agreement or understanding. Example 19. In 1969, two U.S. corporations (A and B) each acquire 30 percent of out- standing voting stock of a foreign corpora- tion (P). Simultaneously, A and B enter into a written stockholders' agreement con- cerning the stock so acquired and the par- ticipation of A and B in the management of P. A and B are an associated group. Example 20. F is a publicly owned foreign corporation. Seventy-five percent of F's out- standing voting stock is owned by foreign nationals, the remaining 25 percent being owned by U.S. citizens and residents no one of whom owns more than 2 percent. In this situation, In the absence of any facts in- dicating that the U.S. shareholders acted, or are acting, in concert with respect to the purchase of F's stock or the voting of such stock, or with respect to the management of F, the U.S. shareholders are not an associated group. Example 21. In 1967, a U.S. citizen and resident (A) became interested in purchasing majority control of a foreign corporation (F). A contacted 20 other "7.S. citizens and residents with a view toward inducing them to purchase stock of F as an investment. Such persons were unknown to each other, but were informed by A that he was orga- nizing a group of U.S. investors to purchase control of F. A informed such other persons that F was being mismanaged and that with proper management F would be a very profit- able venture. Thereafter, A purchased 20 percent of outstanding voting stock of F and 10 other U.S. citizens and residents con- tacted by A each purchased 2 percent of F's voting stock. No express written agree- ment was entered into among A and the other U.S. shareholders with respect to such purchase or with respect to any other matter concerning F, but each of the U.S. share- holders voted for A's nominees for directors. A and the other U.S. shareholders are an associated group. (ii) Aggregate 10 percent interest. An associated group exists only if the aggre- gate of direct and indirect interest in the foreign enterprise acquired or owned by the U.S. persons acting in concert amounts to at least 10 percent. Example 22. In December 1967, three U.S. citizens and residents (A, B, and C) entered Into an agreement pursuant to which each purchased 3 percent of the outstanding vot- ing stock of a foreign corporation (F). A, B, and C are not an associated group, since the aggregate of their interests In F Is only 9 percent. In June 1968, in furtherance of the 1967 agreement, A, B, and C each purchased an additional 2 percent of outstanding voting stock of F. Accordingly, A, B, and C became members of an associated group in June 1968. Whether an associated group would have resulted if only one of them had pur- chased an additional 2 percent of the out- standing voting stock of F, and, if so, as of what date they became members of such group, would depend on all the facts and cir- cumstances surrounding the purchase. Cii) Members of associated group as separate DIs. Unlike members of an affili- ated or family group, members of an associated group are not treated as a single person under the regulations. The principal effect of the associated group rule is to establish a DI-AFN relation- ship. Each member of an associated group is considered a- separate DI in the foreign national (referred to as the "group AFN") owned by the group, with the following consequences: Allowables must be individually elected under § 502 and calculated separately by each member of the group. For compliance purposes (§201), each member of an associated group must com- pute direct investment during 1968 and sub- sequent years without reference to direct in- vestment transactions of other members of the group. Long-term foreign borrowing by one member of an associated group may not be offset against the net transfer of capital or positive direct investment of other mem- bers of the group. However, if two or more members of an associated group elect to be governed by § 503 or § 507, the amount of positive direct invest- ment that they may make in group AFNs is subject to the limitations of § 905(b) (2) (i), (ii) and (iii). See § B905-1 (iv). Foreign balances held by a member of an associated group are calculated without ref- erence to foreign balances held by other members. Under § 905(b)(1), a U.S. person who is a DI by virtue of the associated group rules, but does not own a 10 percent or greater interest in a foreign national, is not subject to the restrictions on liquid foreign balances of § 203(c) and is not required to report such balances (see § 907(c) (1) ) . Seperate reports are required from mem- bers of an associated group, unless they elect to report as a group under § 907(c) (2) . How- ever, even if the members elect to report as a group, compliance is still measured individ- ually. Members of an associated group may be exempt from reporting on Forms FDI-101 (Base Period Report) and FDI-102 (Cumula- tive Quarterly Report) , pursuant to the in- structions to such forms, but only if the associated group as a whole would be exempt if an election under § 907(c) (2) had been made. Example 23. In 1965, three U.S. corporations (A, B, and C) enter into an agreement pur- suant to which each purchases 5 percent of the outstanding voting stock of a United Kingdom corporation (K) from an unaffili- ated foreign national for $500,000 in cash, or a total of $1,500,000. The following also occurs during 1965 and 1966: A lends $200,000 to K, $50,000 of which is repaid in 1966; B sells $500,000 in merchandise to K on open account, the open account indebtedness of K to B being $300,000 at the end of 1966; C contributes $200,000 of equipment to the capital of K; during 1965 and 1966, K earns an aggregate of $3 million and pays dividends of $2 million, of which A, B, and C each re- ceive $100,000. A, B, and C had no other AFNs during 1965 or 1966, individually or collec- tively. A, B, and C are an associated group and K is a group AFN of the associated group. Assuming an election to report as a group is not made under § 907(c) (2), A, B, and C will each submit a separate Form FDI-101 show- ing the following 1504(a)(2) historical allowables in Schedule B (000 omitted) : Corporation A: Purchase of stock of K $500 Loan to K 200 Repayment by K (50) Share in reinvested earnings of K (5% of $3,000 earnings minus $100 dividends) 50 Total positive direct invest- ment 700 Allowable (65% of 50 7 of $700) $227.50 Corporation B: Purchase of stock of K 500 Open account indebtedness 300 Share in reinvested earnings of K 50 Total positive direct invest- ment 850 Allowable (65% of 50% of $850) $276.25 Corporation C: Purchase of stock of K 500 Contribution to capital 200 Share in reinvested earnings of K_. 50 Total positive direct invest- ment 750 Allowable (65% of 50% of $750) $243.75 If A, B, and C had not acted in concert in acquiring the stock of K, none of them would have an historical allowable in Sched- ule B since a DI-AFN relationship would not have existed. Also, if A, B, and C elected to report as a group under § 907(c) (2), they would file a single Form FDI-101 showing aggregate positive direct investment of $2,300,000 in Schedule B during 1965 and 1966 and an aggregate Schedule B allowable of $747,500. However, since compliance by each member of an associated group is measured separately, the FDI-102F would have to indicate in a supplemental state- ment the portion of aggregate positive direct investment and the portion of the aggregate allowable allocable to each member of the group (see § B907-l(iii) ) . Example 24. A, B, and C are members of an associated group, each owning 5 percent of one group AFN. A, B, and C have no other AFNs. By virtue of § 905(b)(1), A, B, and C are not required to limit their liquid foreign balances because none has the 10 percent interest necessary to be an individual DI. In 1968, A, B, and C each made positive direct investment under § 504 of $300,000, or a total of $900,000. During 1969, A, B, and C are exempt from filing quarterly reports on Form FDI-102, provided their total direct invest- ment (negative or positive) does not exceed $1 million from January 1, 1969, through the end of any reporting period. (See General Instruction B to Form FDI-102.) (iv) Associated group investment under §§ 503 and 507. Section 905(b) (2) (i) provides. that positive direct invest- ment made during any year by members of an associated group electing to be gov- erned by § 503 is not authorized if the aggregate of direct investment by all such members of the group during the year in all group AFNs exceeds >$1 mil- lion. Thus, each member of an associated group electing to be governed by § 503 must meet two separate tests: First, ag- gregate positive direct investment by such member in all AFNs (including, but REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 51 not limited to, group AFNs of the associ- ated group) may not exceed $1 million; and second, aggregate direct investment in group AFNs by such member and all other members of the associated group electing to be governed by § 503 may not exceed $1 million. Positive direct invest- ment in group AFNs by members of the associated group electing to be governed by § 504 and positive and direct invest- ment pursuant to the incremental earn- ings allowable of § 506 are not included in computing direct investment for pur- poses of § 905(b) (2)(i). Example 25. X, Y, and Z are members of an associated group having one group APN. X, Y, and Z have no other AFNs. All elect § 503 for 1970 and report as follows ($000 omitted) : Direct invest- ment in the group AFN X (200) Y 500 Z 700 Aggregate 1,000 X, Y, and Z are in compliance for 1970 under §§ 503 and 905(b) (2) (i). Example 26. X, Y, and Z are members of an associated group, each owning a 33>/ 3 per- cent interest in a group AFN (B) in Schedule B. During 1969, X and Y elect to be governed by § 503. Z elects to be governed by § 504(a) , pursuant to which he has a historical allow- able of $400,000 in Schedule B. X transfers $600,000 to B; Y transfers $400,000 and Z transfers $500,000. B has losses of $300,000. All such direct investment is authorized. X and Y together have made $1 million of positive direct investment in B, an amount authorized by § 503 and § 905(b) (2) (i) . Z has made positive direct investment of $400,000 ($500,000 less Z's share of B's losses ($100,- 000)), an amount authorized by §504. (Z's investment is not included in applying § 905 (b) (2) (i) to direct investment made by X and Y.) Example 27. X and Y are members of an associated group with respect to a group AFN (G). X has a wholly owned AFN (A) and Y has a wholly owned AFN (B). X and Y each elect to be governed by § 503 for 1969. X makes positive direct investment of $300,- 000 in G and $600,000 in A. Y makes positive direct investment of $700,000 in G and $300,000 in B. All such positive direct investment is au- thorized. The investment made by X in A and G ($900,000) is authorized by § 503. The investment made by Y in B and G ($1 mil- lion) is authorized by § 503. The investment made by X and Y in G ($1 million) is within the limitation of § 905(b) (2) (i) . Similarly, all members of an associ- ated group that elect § 507 are treated as a single DI with respect to direct in- vestment made by such members in group AFNs. (See § 905(b) (2) (ii) .) Example 28. W, X, Y, and Z are members of an associated group. They all elect § 507 for 1970 and report the following direct in- vestment in their group AFNs ($000 omitted) : Scheduled area A B/C W_ 2,000 X __._ (1,000) 250 Y 2,000 250 Z _ 1,250 250 Aggregate 4,250 750 The foregoing positive direct investment Is authorized by §507, as limited by § 905(b) (2) (ii). If § 503 is elected by some members of an associated group and § 507 is elected by others, direct investment by such members is limited by § 905(b) (2) (iii) in addition to § 905(b)(2) (i), which applies to those electing § 503, and § 905 (b) (2) (ii) , which applies to those elect- ing §507. Section 905(b) (2) (iii) limits direct investment by the members elect- ing § 503 and § 507 to $1 million to the extent made under either § 503 or the $1 million allowable of § 507 (a) (1) and (b). Example 29. W, X, Y, and Z are members of an associated group. W and X elect § 503 for 1970 and report the following direct in- vestment in group AFNs ($000 omitted). Worldwide direct in- vestment W 300 X 400 Aggregate 700 [§503] Y and Z elect § 507 and report the following direct investment in group AFNs ($000 omitted) : Scheduled area A B/C Y_ 2,000 200 Z 2,000 200 Aggregate '4,000 2 400 1 Section 507(a)(2). 2 Section 507(a)(1). Although W and X are in compliance under § 905(b) (2) (i) and Y and Z are in compli- ance under § 905(b) (2) (ii) , W, X, Y, and Z are out of compliance under § 905(b) (2) (iii) to the extent of $100,000, because the aggre- gate direct investment made under § 503 and § 507(a) (1) [$700,000 + $400,000] exceeds $1 million. Assume that Y and Z had reported as follows ($000 omitted) : Scheduled area A B/C Y_ 2,100 50 Z 2,000 150 Aggregate l 4, 100 2 200 1 Consisting of 4,000 [§ 507(a)(2)] and 100 [§ 507(b)]. 2 Section 507(a)(1). W, X, Y, and Z would have been in com- pliance in this case under § 905(b) (2) (iii) because the aggregate of direct investment made under §503 [$700,000], under §507 (a)(1) [$200,000] and under § 507(b) [$100,000] does not exceed $1 million. Note that W, X, Y, and Z in this example, and in Example 28 above, must also measure compliance individually with respect to di- rect investment made in all of their AFNs, both group and those separately held. (v) Related AFNs. Although U.S. per- sons acting in concert must ordinarily own or acquire an interest in the same foreign enterprise before an associated group can exist, there may be instances where ownership or acquisition of in- terests in different foreign enterprises by U.S. persons acting in concert will be sufficient to constitute such persons an associated group. This will be true where the businesses conducted by the different foreign enterprises involved are so re- lated as to justify treating them as a single economic unit for purposes of the regulations. Example 30. A Danish citizen and resident (D) owns all the stock of two Danish cor- porations (E and F). E is engaged in the manufacture of widgets, while F markets the widgets produced by E. The management of E and F is substantially identical. Two U.S. citizens and residents (A and B) enter into an agreement with D pursuant to which A purchases all the stock of E from D, while B purchases all the stock of F from D. A and B have an understanding that the businesses of E and F will be operated in the same integrated manner as they have in the past and that the net profits of E and F will ultimately be split equally between them. A and B are an associated group, and E and F are group AFNs of the associated group. Example 31. Three U.S. citizens and resi- dents (A, B, and C) enter into an agreement to establish a chain of six drive-in restau- rants in continental Europe. Each restaurant is to be established as a separate foreign corporation, and A, B, and C will each own 100 percent of two such corporations. A, B, and C are an associated group, and all of the restaurant corporations are group AFNs of the associated group. (vi) Effect of § 505. Under § 505, cer- tain transfers between AFNs are treated as transfers by the transferor AFN to the DI and as further transfers by the DI to the transferee AFN. This rule applies only if either of the AFNs involved is an "affiliate" of the DI (defined in § 903(a) ) . An AFN is not considered an "affiliate" of the DI unless the DI (itself or together with other affiliates) owns more than 50 percent of the AFN. If, however, in the case of a group AFN of an associated group (a) no one member of the group (either itself or together with other af- filiates of such member) owns more than 50 percent of the AFN, but (b) the mem- bers of the group as a whole (either themselves or together with their af- filiates) own more than 50 percent of the AFN, then (c) the group AFN will be treated as an affiliate of each member of the group for purposes of § 505. Example 32. A, B, C, and D are members of an associated group and F, a French cor- poration, is a group AFN of the associated group. A, B, C, and D each own 25 percent of the outstanding stock of F. F owns all outstanding stock of J, a Japanese corpora- tion. F lends $100,000 to J on a long-term basis. F and J are considered to be affiliates individually of A, B, C, and D for purposes of § 505. Accordingly, under § 505(a) (3) , F is deemed to have made a transfer of capital to A, B, C, and D in the amount of $25,000 each and A, B, C, and D are each deemed to have made a transfer of capital to J in the amount of $25,000. If A were to own 70 percent of F's stock and B, C, and D each held 10 percent, F and J would be considered affiliates of A, but not of B, C, or D, for purposes of § 505. Accord- ingly, the $100,000 loan from F to J would be treated under § 505(a) (3) as a $100,000 trans- fer of capital from F to A, and as a further $100,000 transfer of capital from A to J. (vii) Reporting. Unless an election to report as a group is made under § 907(c) (2), members of an associated group should file separate Forms FDI-101, FDI- 102, and FDI-102F reflecting such mem- ber's individual direct investment trans- REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7. 1970 52 RULES ANB-REGULATIONS actions (see § 905(b) (3) ) . If members of a group file separately, the FDI-102F filed by each member of an associated group should indicate on a supplemental state- ment the names of all other members of the associated group and the names of group AFNs. Each member of the group electing to be governed by § 503 or § 507 should submit a supplemental statement indicating the amount of his direct in- vestment and the direct investment of the other members of the group in group AFNs. § B906-1 Ownership of DIs. A U.S. person may be a DI by reason of either a direct or an indirect interest in an AFN (see § 305). For example, if A and B (U.S. corporations) each own 50 percent of C (a U.S. corporation), and C has a wholly owned AFN (X) , all three corporations are DIs with respect to X. C has a 100 percent direct interest, and A and B each have a 50 percent indirect interest in X (see §§ 901 and 902) . How- ever, unless A and B elect under § 906 / 3 percent of D and consent to an election under 5 906(b)(1). D has an his- torical allowable in Schedule A of $1,200,000 and in Schedule B of zero. During 1968 D's share of annual earnings of Schedule A AFNs was $2 million and of Schedule B AFNs, $1,500,000. As a result, D has a § 504(b) earn- ings allowable in Schedule A of $600,000 and in Schedule B of $450,000. Should A elect to be governed by § 504(a) for 1969, A would acquire, as a result' of § 906(b) (3) (i) . a $400,000 historical allowable in Schedule A and zero in Schedule B. If B and C chose to be governed by the § 504(b) allowable, each would acquire an earnings allowable of $200,000 in Schedule A and $150,000 in Schedule B. Example 36. A, B, C, and D each own 25 percent of E. E has an historical allowable REPRINTED FROM FEDERAL REGISTER, VOL. 35. NO. 195— WEDNESDAY. OCTOBER 7, 1970 RULES AND REGULATIONS 53 in Schedule A of $800,000. During 1969, E re- pays a 1967 long-term foreign borrowing (au- thorized borrowing under § 1002) and Incurs a repayment charge under § 1003 of $2 mil- lion in Schedule A. E has no AFNs in Sched- ules B or C. A, B, C, and D make a§ 906(b) (1) election. For 1969, A elects to be governed by § 504(a) with an historical allowable in Schedule C of $500,000, in Schedule B of $600,000, and zero in Schedule A (other than what is pvailable as A's pro ,rata share of E's historical allowable). A's rro rata share of the repayment charge ($500,000) reduces A's Schedule A allowable ($200,000, derived from E by virtue of the § 906(b) (1) election) to zero, and the excess ($300,000) reduces A's allowables in Schedule C from $500,000 to $200,000 (see § 1003). The Schedule B al- lowable is not affected. Consenting owners may utilize allow- ables passed on to them by virtue of a § 906(b)(1) election either to make in- dividual positive direct investments in AFNs of the principal DI or in their own AFNs. However, positive direct invest- ment by the principal DI will be charged to consenting owners on the same pro- rata basis as allowables are "passed on". Thus, if the principal DI makes positive direct investment in any year that ex- ceeds the applicable allowable "passed on" to the consenting owners, such own- ers might be in violation of § 201. (iv) Election by affiliated groups. Members of an affiliated group are deemed to be a single person under the regulations, except for pumoses of mak- ing an election under § 906(b)(1) in which case they are treated as separate persons. However, the purpose of this rule is to make the § 906(b) (1) election available to members of an affiliated group, and not to break up the affiliated group. Example 37. A, B, and C are U.S. corpora- tions. A owns 51 percent of C and B owns 49 percent. A and C are an affiliated group. Nevertheless, A may elect under § 9D6(b) (1). If both A and B elect under § 906(b) , A will assume 51 percent of C's direct Investment position, and B will be accorded 49 percent. However, A and C are still an affiliated group and therefore will be treated as one person with respect to 51 percent of C's direct invest- ment transactions. Example 38. A, B, C, and D are all U.S. corporations. A owns 80 percent of D, and B and C each own 10 percent of D. B owns 100 percent of C. A and D are an affiliated group, and B and C are another affiliated group. If A, B, and C make a § 906(b)(1) election with respect to D, the A-D affiliated group will report as to 80 percent of D's direct investment and the B-C affiliated group will report as to 20 percent of D's direct investment. (v) Limitation on use of §§ 503 and 507 by consenting owners. If direct own- ers electing under § 906(b) (1) also elect to be governed by the § 503 minimum allowable, the $1 million allowable is not divided proportionally among the con- senting owners, as are the §§ 504 and 506 allowables. Instead, § 906(b) (3)(ii) pro- vides that the aggregate of direct in- vestment made, and deemed made, by all consenting and nonconsenting owners in AFNs of the principal DI may not ex- ceed $1 million. Thus, each consenting owner electing to be governed by § 503 must meet two separate tests: First, aggregate positive direct investment made by such mem- ber in all AFNs (including, but not lim- ited to, AFNs of the principal DI) may not exceed $1 million; second, aggregate direct investment in AFNs of the prin- cipal DI by such owner and all other consenting and nonconsenting owners electing to be governed by § 503 may not exceed $1 million. (This parallels the requirements of § 905(b) (2) (i) appli- cable to individual members of associ- ated groups.) In computing aggregate direct investment under § 906(b) (3) (ii), direct investment in AFNs of the prin- cipal DI by consenting owners electing to be governed by § 504 and positive di- rect investment made under the § 506 in- cremental earnings allowable are not included. Example 39. A, B, C, and D, U.S. citizens and residents, each own a 25 percent inter- est in E, a U.S. corporation, and consent to an election with respect to E under § 906(b) ( 1 ) . E owns all outstanding stock of foreign corporations P, G, and H. A, B, C, and D elect to be governed by § 503 for 1969. During 1969, E makes a $100,000 long-term loan to P, contributes $200,000 to capital of G, and sells $250,000 of merchandise to H on credit. F, G, and H earn an aggregate of $50,000 but pay no dividends to E. Also during 1969, A makes a long-term loan of $100,000 each to F and G, while C makes a long-term loan of $250,000 to H. E's total positive direct in- vestment is, therefore, $600,000, of which $150,000 (25%) is allocable each to A, B, C, and D because of the election. In addi- tion, A has made positive direct invest- ment of $200,000 and C has made positive direct Investment of $250,000. The total posi- tive direct investment made and deemed made in all AFNs of E by A, B, C, and D is, therefore, $350,000 for A, ($150,000 plus $200,000), $150,000 for B, $400,000 for C ($150,000 plus $250,000), and $150,000 for D. To the extent that the total ($1,050,000) exceeds $1 million, A, B, C, and D are all in noncompliance. Example 40. A, B, and C each own 33% percent of D. A and B elect under § 906(b) (1) . C does not consent to the election. A, B, and C each elect to be governed by § 503 for 1969. During 1969 D makes positive direct investment of $900,000. C lends $150,000 to D's AFNs. The direct investment deemed made by A and B violates the limitation of § 906(b) (3) (ii), because aggregate direct in- vestment made and deemed made by them and the nonconsenting owner (C) in the principal DI's AFNs exceeds $1 million. Example 41. A, B, C, and D, each owning 25 percent of E, consent to an election under § 906(b)(1) with respect to E. In addition, they all elect to be governed by § 503 for 1969. In 1969 E makes a $500,000 repayment under § 1002. By operation of § 1003, each consenting owner's § 503 allowable is re- duced by $125,000 (25 percent of the tatal re- payment charge) so that each may make only $875,000 of positive direct investment in all AFNs (including, but not limited to, AFNs of E) . In addition, the aggregate direct investment made by A, B, C, and D in AFNs of E during 1969 may not exceed $500,000 (§ 906(b) (3) (ii)). Similarly, consenting owners of a prin- cipal DI that elect § 507 are treated as a single DI with respect to direct invest- ment made, and deemed made, by them in AFNs of the principal DI. See § 906 (b)(3) (hi). This provision is analogous to § 905(b) (2) (ii) illustrated in Example 28, above. If § 503 is elected by some consenting owners of a principal DI and § 507 is elected by others, direct investment by such consenting owners is limited by § 906(b) (3) (iv) in addition to § 906(b) (3)(ii), which applies to those electing § 507. Section 906(b) (3) (iv) limits direct investment by all- direct owners electing §§ 503 and 507 to $1 million to the extent made under either § 503 or the $1 million allowable of § 507 (a) (1) and (b). This provision is analogous to § 905(b) (2) (hi), illustrated in Example 29, above. § B907-1 Reporting. Section 907 sets forth a number of rules concerning the responsibility of DIs to file base period, quarterly and annual reports under § 602. The general rule is that all DIs must file reports unless exempt from reporting as provided by the instructions to the applicable reports or by § 907(b) (3) or § 907(c) (2) . It is important to note that persons consenting to an election under § 906(b)(1), and members of an asso- ciated group, are not exempt from re- porting on Forms FDI-101, FDI-102, and FDI-102F under the provisions of the instructions to such forms, unless the "principal DI" or the associated group as a whole would be exempt. (i) Consenting owners. Section 907 (b) (1) provides that if a U.S. person consents to an election under § 906(b) (1) with respect to any principal DI, re- ports filed by such person should include such person's pro rata share (calculated as provided in § 906(b) (3) (i) ) of the amount of foreign balances, direct in- vestment and other items that the prin- cipal DI would have included in its re- ports had the election not been made. Example 42. A U.S. corporation (D) owns 25 percent of U.S. corporation (E) and 40 percent of U.S. corporation (F) . Elections are made under § 906(b) (1) with respect to both E and F with D and all other U.S. stock- holders of E and F consenting to such elec- tions. During 1969 E makes positive direct investment of $1 million in Schedule A and $2 million in Schedule B, while F makes positive direct investment of $500,000 in Schedule A and $300,000 in Schedule B. D also has a number of directly owned for- eign subsidiaries in Schedules A and B, and D itself makes positive direct Investment of $1 million in Schedule A and $800,000 in Schedule B during 1969. The Form FDI-102F filed by D for 1969 should show positive di- rect investment of $1,450,000 in Schedule A ($1 million plus 25 percent of $1 million plus 40 percent of $500,000) and $1,420,000 in Schedule B ($800,000 plus 25 percent of $2 million plus 40 percent of $300,000). (ii) Nonconsenting owners and owners of indirect interests. Section 907(b)(2) provides that reports filed by a U.S. per- son should not include any direct invest- ment or other items attributable to (a) DIs in which the U.S. person owns merely an indirect interest, or (b) DIs in which the U.S. person owns a direct interest but has not consented to an election under § 906(b)(1). Example 43. A U.S. citizen and resident (D) owns 25 percent of a U.S. corporation (E) , which In turn owns 50 percent of another UJ3. corporation (F). D also owns 50 percent of U.S. corporation (G) and 40 percent of U.S. corporation (H) . No elections REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 54 RULES AND REGULATIONS tre made under § 906(b) (1) with respect to corporation E, F, or G. An election is made under § 906(b)(1) with respect to corpora- tion H, but D does not consent to the elec- tion after being given a reasonable oppor- tunity to do so. During 1969 E, P, G, and H, with various APNs throughout the world make positive direct investment of $1 mil- lion, $500,000, $800,000 and $600,000, respec- tively. Also during 1969, D himself makes positive direct investment of $200,000 by cash purchase of foreign commercial real estate from an unaffiliated foreign national. The Form FDI-102F filed by D for 1969 should include his own positive direct investment of $200,000, but should not include any of the positive direct investment made by E, F, G, or H. If D had made no positive direct invest- ment of his own during 1969, D would not be required to file reports on Forms FDI-102 and FDI-102F for 1969. (iii) Associated groups. Section 907(c) ( 1 ) provides that reports filed by a mem- ber of one or more associated groups should include all direct investment made by such person in group AFNs of the relevant associated groups. Although the general rule is that each member of an associated group files a separate re- port under § 602 showing his own direct investment transactions, § 907(c) (2) permits a majority in interest of an associated group to elect, subject to the approval of OFDI, to have the group file a single report showing direct investment transactions of all members of the group in all group AFNs during the relevant period. The election is made by filing a notice of election with the Program Re- ports Branch of OFDI, the notice being executed by or on behalf of a majority in interest of the group. Notwithstanding an election under § 907(c) (2) , each mem- ber of an electing associated group hav- ing independent direct investment trans- actions with respect to AFNs other than group AFNs must file separate reports reflecting such transactions. Example 44. (a) A U.S. citizen and resident (A) is a member of two different associated groups (Gl and G2). The group AFN of Gl is a French corporation (F) and the group AFN of G2 is an Australian corporation (K). A owns 5 percent of outstanding voting stock of F and 8 percent of outstanding voting stock of K. A also owns all outstand- ing stock of a Panamanian corporation (P). The following occurs during 1969: A con- tributes $100,000 to capital of K; F earns $80,000 and pays a dividend of $40,000, of which $2,000 was paid to A; K earns $200,000 and pays a dividend of $100,000, of which $8,000 is paid to A; A lends $300,000 to P on a long-term basis; P earns $50,000 and pays no dividends to A. Neither Gl nor G2 elects to report as a group. A's Form FDI- 102F for 1969 should show positive direct investment of $350,000 in Schedule A (the $300,000 loan to P plus $50,000 reinvested earnings of P), positive direct investment of $108,000 in Schedule B (the $100,000 loan to K plus $8,000 reinvested earnings of K) and positive direct investment of $2,000 in Schedule C ($2,000 reinvested earnings of F) . (b) Should G2 elect, with approval of OFDI, to report as a group under § 907(c) (2), the Form FDI-102F filed by A for 1969 will not include the $108,000 of positive di- rect investment made by A in K (Schedule B) . The FDI-102F filed by G2 will Include all positive direct investment made by the mem- bers of G2 (including A's positive direct in- vestment of $108,000) in K (Schedule B). (c) If A does not own any stock of P, and Gl and G2 both elect, with approval of OFDI, to report as a group under § 907(c) (2), Gl will file a Form FDI-102F for 1969 showing the positive direct investment made by all members of Gl (including A's positive direct investment of $2,000) in F (Schedule C) and G2 will file a Form FDI-102F for 1969 showing the positive direct investment made by all members of G2 (including A's positive direct investment of $108,000) in K (Schedule B) . A himself will not file a Form FDI-102F for 1969. It is essential to recognize that com- pliance by each member of an associated group is measured separately and with- out reference to direct investment trans- actions of the group's other members, whether or not the group elects to report as a group under § 907(c) (2). The only exception to this rule is contained in § 905(b) (2), with respect to cumulation of direct investment transactions with group AFNs by members of a group electing § 503 or § 507. Accordingly, the Form FDI-102F filed by a member of the group under § 907(c) (2) should indicate, on a supplemental statement, the portion of the group's direct investment allocable to each member of the group. (iv) Affiliated and family groups. Sec- tion 907(d) provides that reports filed by an affiliated or family group for any period should aggregate all direct invest- ment transactions and other reportable items attributable to each member dur- ing the relevant period. Example 45. A U.S. corporation (A) owns 60 percent of outstanding voting stock of another U.S. corporation (B), and 80 per- cent of outstanding voting stock of a third U.S. corporation (C). B owns a 70 percent interest in a U.S. partnership (P) . All out- standing stock of A is owned by a U.S. citizen and resident (D) . During 1969, A makes posi- tive direct investment of $100,000, B makes positive direct investment of $200,000, C makes positive direct investment of $300,000, D makes positive direct investment of $50,000, and P makes positive direct invest- ment of $150,000. The Form FDI-102F filed by the affiliated group of A, B, C, D, and P for 1969 should show positive direct invest- ment of $800,000, allocated among the ap- propriate scheduled areas. A, B, C, D, and P need not file a separate Form FDI-102F. Had A and all other stockholders of B made an election under § 906(b)(1) with respect to B, the Form FDI-102F filed by the affili- ated group for 1969 would include only 60 percent of B's positive direct investment, rather than the entire $200,000. Total posi- tive direct investment to be reported by the group will, therefore, be $720,000. B1000 — Subpart J (§§ 1001-1003) § B1000-1 Introduction. Direct investment may be made by DIs with proceeds of long-term foreign bor- rowing without current charge to allow- ables. Repayment of a long-term foreign borrowing is a transfer of capital under § 312(a) (7) if the proceeds of such bor- rowing have been expended in making transfers of capital or allocated to posi- tive direct investment. The transfer of capital under § 312(a) (7) is deemed to have been made to the scheduled area or areas where the last deduction or deduc- tions with respect to the proceeds have been made. Furthermore, satisfaction by a DI of the debt obligation of its AFN is a transfer of capital under § 312 (a) (6). Repayment by a DI either of its own long-term foreign borrowing or of an AFN borrowing may, therefore, result in positive direct investment prohibited by § 201, if such positive direct investment is in excess of the amount authorized to the DI under Subpart E. However, § 1002 (a) generally authorizes positive direct investment (which may be in excess of applicable Subpart E or M allowables) attributable to transfers of capital re- sulting from repayment of certain bor- rowings enumerated therein. The general authorization under § 1002 (a) applies to: (a) Repayment of long- term foreign borrowings made prior to January 1, 1968; (b) repayment by a DI, pursuant to a guarantee, of AFN borrow- ings made prior to January 1, 1968; (c) repayment of AFN borrowings not guar- anteed by the DI if the borrowings were made from a bank prior to January 1, 1968; and (d) repayment of AFN bor- rowings made from a bank after Jan- uary 1, 1968, pursuant to a fixed loan commitment established by the AFN prior to that date. Section 1002(a) thus authorizes repayment of borrowings con- tracted prior to the effective date of the program. Section 1002(a) also authorizes repay- ment by a DI of borrowings made by an AFN and guaranteed by the DI, on or after June 10, 1968, provided that the DI files, with respect to the borrowing, a certificate described in § 1002(b). In the certificate, the DI must state, in light of all facts and circumstances existing at the time of the guarantee, that it has reason to believe either that the DI will not make any repayment of the borrow- ing within 7 years of the guarantee, or that any positive direct investment re- sulting from repayment within 7 years will not exceed the amount of positive direct investment authorized by Sub- part E. The section similarly authorizes repayment of a DI's own long-term for- eign borrowing made on or after June 10, 1968, provided that the DI files a similar certificate with respect to the long-term foreign borrowing. Section 1002(a) further authorizes re- payment of a DI's borrowing made dur- ing the period from January 1, 1968, through June 9, 1968. During that pe- riod the predecessor of Subpart J, Gen- eral Authorization No. 1, was in effect. General Authorization No. 1 authorized repayment of a DI's long-term foreign borrowing and an AFN borrowing guar- anteed by the DI, conditioned upon the filing of a certificate similar to the cer- tificate required by present § 1002(a). Finally, § 1002(a) authorizes repay- ment by the DI of a long-term foreign borrowing or a borrowing by an AFN, whether or not guaranteed by the DI, if repayment occurs by issuance of stock of the DI pursuant to conversion by holders of debt obligations issued by the DI (or its AFN) in connection with the borrowing. Although repayments pursuant to § 1002(a) are authorized independently of Subpart E or M allowables, any re- sulting positive direct investment has the effect of reducing such allowables. Under REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 55 § 1003, the amount of such positive direct investment constitutes a "repayment charge" which reduces first the allow- able in the scheduled area where the transfer of capital is recognized pursuant to § 312(a) (6) or (7), then the allow- ables in Schedules C, B, and A, in that order, and finally the allowables in future years in the same manner. Total reduc- tions will equal the amount of positive direct investment resulting from repay- ment, but the charge does not reduce al- lowables in any scheduled area to less than zero in any year. Reduction of al- lowables occurs in the year in which re- payment is made, except for repayment by means of conversion of debt obliga- tions into stock of the DI, in which case the repayment charge is incurred in the following year (see § 1002(a)(3)). Section 702 should be read in conjunc- tion with Subpart J. This section is in- tended to make clear that a lender may enforce obligations entered into with DIs or AFNs, whethrr or not performance by the obligor is authorized by the regu- lations, absent the lender having actual knowledge at the time the borrowing is made that the use of the proceeds thereof, the repayment thereof, or any other transaction in connection there- with will constitute a violation by the DI of the regulations. § B1001— 1 Definition of borrowing by a DI and by an AFN. Section 1001(b) defines the term "borr rowing by a DI" as a borrowing by a DI repayment of which would constitute a transfer of capital under § 312(a) (7), which applies to any long-term foreign borrowing (as defined in §324), the proceeds of which have been expended in making transfers of capital or allo- cated to positive direct investment. Re- payment of borrowings by the DI that are not long-term foreign borrowings, and repayments of long-term foreign borrowings, the proceeds of which have not been expended or allocated, do not result in transfers of capital. Section 1001(a) defines the term "bor- rowing by an AFN"'. As is the case with a DI's long-term foreign borrowing, a "borrowing by an AFN ' includes not only the typical loan of funds and sale of debt obligations, but may also include other transactions, the practical economic ef- fect of which is that the AFN acquires an interest in property, with all or part of the payment deferred to some future date. Thus, for example, an installment purchase of property by an AFN may in- volve a "borrowing" for purposes of Sub- part J. (See § B324-4.) Section 1002 (e)(1) provides that a bor- rowing by a DI or by an AFN is deemed to have been made on the date the pro- ceeds are received by the borrower, or, if a purchase of property on credit is in- volved, on the date the property is pur- chased. If, however, the borrowing in- volves a public offering of securities, the borrowing is deemed to have been made on the date the securities are issued, and if the borrowing involves the use of an overdraft facility, the borrowing is deemed to have been made when the overdraft is used. The date of a borrow- ing is significant in determining (1) whether the borrowing, if made by a DI, qualifies as long-term foreign borrowing under § 324, and (2) whether any re- payments of the borrowing are expected to be made within 7 years from the date thereof. As is the case with respect to a long- term foreign borrowing under § 324(b) (1) , the refinancing of a borrowing by an AFN, by virtue of renewal, extension or continuance thereof or a subsequent bor- rowing from the same or another lender, is not a repayment of the borrowing or the making of a new borrowing. (See 1002(e) (2).) Delivery of equity securities of a DI to holders of debt obligations issued by an AFN, in exchange for the debt obligations of the AFN, constitutes repayment by the DI of the AFN's borrowing ( a transfer of capital under § 312(a) (6) in the amount of the debt retired). Such treatment is analogous to the treatment of delivery of equity securities of a DI in exchange for the debt obligations issued in connec- tion with a long-term foreign borrowing. (See §B324-11 regarding repayment by conversion with respect to long-term for- eign borrowing.) There are, however, some significant differences between a borrowing by an AFN (other than borrowings by an OFS covered by Subpart N) and a long-term foreign borrowing by a DI. First, while a DI's long-term foreign borrowing must be made from a foreign person (other than a Canadian person), a borrowing by an AFN may be made from any person, including a United States or a Canadian person, so long as such person is neither an AFN of the DI nor the DI itself. Second, expenditure or allocation of proceeds of long-term foreign borrowing by the DI will give rise to deductions from net transfer of capital and positive direct investment, under §§ 313(d)(1) and 306(e). Although neither the 'bor- rowing by an AFN" nor a guarantee thereof by the DI constitutes a transfer of capital by the DI, investment by the AFN of funds received from its borrow- ing in other AFNs ox the DI may result in transfers of capital under §§ 505 and 312. Third, while repayment of a DI's long- term foreign borrowing results in a trans- fer of capital under § 312(a) (7), if the proceeds thereof have been expended or allocated, repayment of a "borrowing by an AFN" by the AFN will not result in a transfer of capital. Repayment of such borrowing by the DI, however, will result in a transfer of capital under § 312(a) (6) to the borrower AFN, since repayment indirectly increases the DI's debt or equity interest in the AFN. Note that the treatment under Sub- part N of an "overseas borrowing" by an AFN that qualifies as an OFS of the DI is substantially different from the normal AFN borrowing. See §§ B1401-1405. § B1001— 2 Borrowing by a business ven- ture AFN. The identity of a borrower is normally ascertainable by reference to the instru- ment evidencing the debt obligation. However, when a borrowing transaction is purportedly entered into by a business venture AFN that is a direct branch of a DI (as described in § 304(a) (1) (ii) ), identity of the actual primary obligor is difficult to ascertain. Similar difficulty is encountered when a borrowing is pur- portedly made by a business venture AFN that is a branch of an incorporated AFN (as described in § 304(a) (1) (iii) ) . Since the regulations distinguish between borrowing by a DI and borrowing by an AFN for many purposes, DIs are advised to submit transactions involving ques- tions of this nature to OFDI for an interpretation. § B 1001— 3 Definition of guarantee. The term "guarantee" is defined in § 1001(c). The written acknowledgement of secondary responsibility referred to in § 1001(c)(1) is confined to acknowl- edgements given to a bank. Such ac- knowledgements refer to general assur- ances of repayment that, in the typical case, are not intended to be legally en- forceable against the DI but represent a moral commitment of the DI that the loan will be repaid. The written guarantee, endorsement, etc., specified in § 1001(c)(2), refers to the customary legally binding commit- ment whereby the DI guarantees pay- ment of principal and interest by, or collection thereof from, an AFN. It does not include subordination agreements. The reference to "through-put" agree- ments, "take or pay" contracts, "keep- well" agreements and similar written agreements in § 1001(c) (3) covers cer- tain types of financial arrangements designed to assure that the AFN will have sufficient funds to repay the relevant borrowing. Generally, a "through-put" agreement is an agreement (typically made by companies in the extractive in- dustries) whereby the DI agrees to put certain types of raw materials through a particular processing, refining or de- livery facility of an AFN, while a "take or pay" contract is a supply agreement whereby the DI contracts to pay for production made available by the AFN, whether or not the DI in fact accepts de- livery. A "keep-well" agreement refers generally to an agreement whereby the DI agrees to supply sufficient funds to the AFN for working capital to enable repayment of the borrowing in question. Section 1001(c)(4) provides that mortgages, pledges, or hypothecations of property made by a DI as security for repayment of a borrowing by an AFN will constitute a "guarantee" if the transaction does not involve a transfer of capital by the DI under § 312(a) (9) . The guarantees described in § 1001 (c) (2) -(4) are not limited to transactions involving banks. Example 1. DI pledges stock of a domestic "affiliate" to a domestic bank as security for a borrowing by an AFN from such bank. The pledge constitutes a guarantee under S 1001(c) (4). Example 2. DI pledges equity securities of foreign corporations that are not AFNs to a domestic bank as security for a borrowing by an AFN from a foreign branch of such bank. The pledge constitutes a guarantee under § 1001(c) (4). REPRINTED FROM FEDERAL REGISTER. VOL. 35, NO. 195— WEDNESDAY. OCTOBER 7, 1970 56 RULES AND REGULATIONS Example 3. DI pledges a Deutsche Mark deposit in a German bank as security for a borrowing by an AFN from such bank. The pledge constitutes a transfer of capital un- der § 312(a) (9) and does not constitute a guarantee under § 1001(c) (4). Example 4. DI pledges a demand deposit in a domestic bank as security for a borrowing by an AFN from a foreign branch of such bank. The pledge constitutes a guarantee under § 1001(c) (4). The term "guarantee" includes a guar- antee given by one AFN in respect of a borrowing by another AFN of the same DI, if repayment pursuant to the guar- antee would result in a transfer of capi- tal by the DI under § 505. A § 312(a) (6) transfer of capital would be charged to the DI by operation of § 505(a) (3) if the guarantor AFN that makes repayment pursuant to the guarantee is an affiliate of the DI under § 903(a) . Example 5. DI has two APNs: A wholly owned subsidiary in Panama (P) that in turn has a wholly owned subsidiary in Sweden (S). S borrows from a foreign bank. Repayment of the borrowing is guaranteed by P. If P is called upon to repay the borrow- ing of S, the payment (whether made directly to the lender or to S) is deemed a transfer from Schedule A to the DI and from the DI to Schedule C, pursuant to § 505(a) (3). Any positive net transfer of capital to Schedule C attributable to the transfer deemed made by the DI will generally be authorized under Subpart J if the DI files a certificate (Form FDI-106) within 10 days after the execution of the guarantee by P. § B1001-4 DI's guarantee of an AFN borrowing. Except for certain AFN borrowings from banks made prior to January 1, 1968, and those repaid through conver- sion into stock of the DI, § 1002(a) au- thorizes repayment by a DI of an AFN's borrowing only if made pursuant to DI's guarantee of such borrowing. Thus, in most cases, in order for repayment to be authorized, there must be both a "guar- antee" and a "borrowing by an AFN", as those terms are defined in § 1001. Example 6. DI's AFN arranges to borrow $1 million from a New York bank. On June 1, 1970, AFN receives $1 million from the bank and gives the bank a note in that amount, payable in 2 years, and also gives the bank a guarantee of repayment of principal and interest executed by the DI. On June 1, 1970, the AFN has made a borrowing that is guaranteed by the DI. Example 7. On June 1, 1970, DI's AFN receives machinery purchased from an English manufacturer with a value of $1 million. Under the terms of the purchase agreement, $250,000 is payable upon receipt of the machinery, the remainder being pay- able in three equal annual installments of $250,000 (plus interest), commencing 1 year from date of receipt of the machinery. Upon receipt of the machinery, the AFN delivers to the seller a guarantee of repayment of principal and interest executed by the DI. On June 1, 1970, AFN has made a borrowing guaranteed by the DI. Example 8. On June 1, 1970, DI's Schedule C AFN, pursuant to a purchase agreement previously entered into, acquires all the stock of a corporation in Schedule A for $2 million. The AFN must pay $500,000 at the closing on June 1, the remainder being payable to the selling shareholders of the foreign corpora- tion in five equal annual installments of $300,000 (plus interest), commencing 1 year from the closing date. At the closing, the AFN delivers to the selling shareholders a guarantee of payment of the principal and interest executed by the DI. On June 1, 1970, the AFN has made a borrowing guaranteed by the DI. (Acquisition of the Schedule A corporation will result in a transfer of cap- ital, under §§ 505 and 312(a) (1), of $2 million from the Schedule C AFN to the DI and from the DI to the Schedule A AFN. Since the borrowing is not a long-term foreign bor- rowing as defined in § 324(a), no deduction with respect to net transfer of capital will be received by the DI. If the DI must repay the borrowing pursuant to the guarantee, a transfer of capital to the Schedule C AFN will result under § 312(a) (6).) Example 9. DI's AFN arranges with a group of investment banking organizations for the sale of 12-year debentures in face amount of $10 million to be dated September 1, 1970. The debentures will be guaranteed by the DI as to payment of principal, interest and premium (if any). The debentures also will be convertible into common stock of the DI. On September 5, 1970, an underwriting agree- ment is signed pursuant to which the de- bentures are to be sold to the underwriters at a discount of 3 percent and sold to the public at par. At the closing on September 25, 1970, AFN issues the debentures and re- ceives a check from the underwriters for $9,500,000, the 3 percent discount and other underwriting commissions, fees and expenses having been deducted. On September 25, 1970, the AFN has made a borrowing of $10 million guaranteed by the DI. Example 10. DI's Schedule C AFN (C) ar- ranges with a group of investment banking organizations for the sale of $10 million of 12-year debentures to be dated September 1, 1970. The debentures will be guaranteed by DI as to payment -of principal, interest, and premium (if any). Attached to the deben- tures will be warrants which may be detached after a period of 6 months from the date of issuance and which entitle the holder to purchase a certain number of shares of the common stock of DI at a specified price. The warrants are valued by DI's independent financial counsel at $750,000 (a valuation acceptable to OFDI). On September 5, 1970, an underwriting agreement is signed pur- suant to which the debentures are to be sold to the underwriters at a discount of 3 percent and sold to the public at par. At the closing on September 25, 1970, C issues the debentures and receives a check from the underwriters for $9,500,000, the 3 percent discount and other underwriting commis- sions, fees, and expenses having been de- ducted. C has made a borrowing of $10 mil- lion guaranteed by the DI on September 25, 1970. On the same date DI is considered to have made a transfer of capital under § 312 (a) to C in the amount of the value of the warrants ($750,000) that are attached to the debentures. Example 11. On September 15, 1968, DI's AFN entered into a revolving credit arrange- ment with a foreign bank, pursuant to which AFN could borrow up to $5 million during a period ending September 15, 1975. The agree- ment provided that each takedown under the arrangement would be evidenced by a 180-day note, each note being renewable by its terms within the overall period of the arrangement. DI executed and delivered to the foreign bank a guarantee of payment of principal and " interest of any borrowings made by the AFN pursuant to the revolving credit arrangement. On October 1, 1968, AFN took down $3 million and on February 1, 1969, it took down $2 million. AFN made a borrowing guaranteed by the DI of $3 million on October 1, 1968, and another borrowing guaranteed by the DI of $2 million on Feb- ruary 1, 1969. The authorization contained in § 1002 (a) is limited to repayment of a guaran- teed borrowing. Payments made by a DI pursuant to guarantees of performance by its AFN of contractual obligations other than the repayment of debt are not authorized by § 1002(a). Example 12. DI has a Schedule C AFN (C) that is engaged in the business of road con- struction. C enters into a contract with a foreign government for construction of a highway that must meet certain specifica- tions. DI guarantees performance by C of the contract according to specifications con- tained therein. If DI is called upon to pay money to the foreign government or to transfer funds to the AFN to enable per- formance according to the contract specifi- cations, the payment or transfer is not auth- orized by § 1002(a). Example 13. DI has a Schedule C AFN in- volved in the construction business. From time to time, AFN makes bids on certain construction projects, in connection with which the AFN must file a bond that is for- feited if AFN is let a contract that it cannot perform. AFN has an arrangement with its local bank, in the form of an overdraft whereby the bank will pay any such for- feited amounts. DI has issued a guarantee of payment of principal and interest of any amounts paid by the bank pursuant to its arrangement with the AFN. If the AFN uti- lizes the arrangement to pay a forfeit which results in an overdraft, the AFN, at that time, will have made a borrowing guaranteed by the DI, and repayment by the DI may be authorized under § 1002(a). Example 14. On July 1, 1969, DI's AFN entered into a 20-year charter-hire agreement with an unaffiliated foreign national (X) for a ship. The terms of the charter-hire agree- ment with X are construed by AFN's public accounting firm as an installment purchase under accounting principles generally ac- cepted in the United States, and AFN treats an appropriate portion of the charter-hire payments as return of principal to X and treats the remainder as interest charges. Under the charter-hire agreement, AFN also agrees, among other things, to keep the ship in good repair, to keep it clear of any liens, and to hold X harmless from any liabilities that may arise out of the operation of the ship. At the closing, DI executes and delivers to X a guarantee of payment and perform- ance of all of the obligations of AFN under the charter-hire agreement. At the closing, AFN has made a borrowing guaranteed by the DI in the amount of the aggregate prin- cipal portion of charter-hire payments to be made during the term of the charter-hire agreement. The DI's guarantee of any other obligations of AFN under the charter-hire agreement is not a guarantee of a borrowing by the AFN, and any payments or transfers to the AFN to enable it to perform any such obligation cannot be authorized under § 1002(a). Renewal of a prior guarantee, or execu- tion of a guarantee upon refinancing of a previously guaranteed AFN borrowing, is not considered to be a new guarantee unless the principal amount guaranteed is increased. Moreover, r:_.. ..al of a guarantee or execution of a new guaran- tee with respect to an AFN borrowing that is still outstanding is not considered to be the making of a new guarantee. Example 15. On September 1, 1968, DI's AFN entered into a revolving credit agree- ment with a foreign bank (X) that permitted AFN to borrow up to $2 million. The borrow- ing was guaranteed by DI. AFN immediately REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 57 took down the entire $2 million. On Sep- tember 1, 1969, AFN makes a $2 million bor- rowing from another foreign bank (Y), giving Y a 3-year note in the principal amount of $2 million. The $2 million is used to repay APN's borrowing from X. Even though DI executes a new guarantee of re- payment of the 3-year note in favor of Y, DI is not considered to have made a new guarantee. Example 16. On September 1, 1968, DI's AFN entered into a revolving credit agree- ment with the foreign branch of a United States bank for a period of 5 years. Under the agreement, AFN could make borrowings of up to $5 million evidenced by 180-day notes renewable by their terms. The agree- ment also provided that the DI guarantees repayment of each 180-day note as to the payment of principal and interest. On Sep- tember 1, 1968, AFN immediately took down the full $5 million. On March 1, 1969, AFN executed new 180-day notes for the full $5 million and delivered to the bank a new guarantee of DI with respect to the new notes. DI is not considered to have made a new guarantee. § B1002-1 Authorizalion of positive di- rect investment attributable to repay- ment of certain borrowings. Positive direct investment attributable to a DI's repayment of an AFN's borrow- ing is authorized by § 1002(a) if: The borrowing was guaranteed by the DI prior to January 1, 1968 (5 1002(a)(1); The borrowing was guaranteed by the DI on or after January 1, 1968, but prior to June 10, 1968, and the DI complied with the certification requirements of § 2(a) (1) of General Authorization No. 1 (§ 1002(a) (1) ); The borrowing was guaranteed by the DI on or after June 10, 1968, and the DI com- plied with the § 1002(b) certification re- quirements (5 1002(a)(5)): The borrowing was obtained from a bank prior to January 1, 1968 (§ 1002(a) (2)); The borrowing was obtained from a bank on or after January 1, 1968, pursuant to a fixed loan commitment or line of credit established prior to January 1, 1968, or any renewal or extension thereof (§ 1002(a) (2) ) ; or The borrowing involved issuance of debt obligations by the AFN convertible into stock of the DI (the date of the borrowing being irrelevant), and repayment by the DI consists of delivery of DI's stock upon "ex- ercise of conversion rights (§ 1002(a) (3) ). Positive direct investment attributable to repayment of a DI's long-term foreign borrowing is also authorized by § 1002 (a) if: The borrowing was made p-ior to Janu- ary 1, 1968 (§ 1002(a) (4)): The borrowing was made from January 1, 1968, through June 9. 1968, and the DI complied with the certification requirements of §2(b) of General Authorization No. 1 (§ 1002(a) (4)); The borrowing was made on or after June 10, 1968, and the DI complied with the § 1002(b) certification requirements (§ 1002 (a)(6)); or The borrowing involved the issuance of debt obligations of the DI convertible into stock of the DI, and repayment by the DI consists of delivery of the DI's stock upon exercise of conversion rights (§ 1002(a) (3)). Section 1002(a) authorizes not only a DI's actual repayment of the enumerated AFN borrowings, but also transfers of capital by a DI to AFNs to enable direct repayment of such borrowings. However, § 1002(d) provides that posi- tive direct investment by a DI is not authorized under § 1002(a) if repayment of the borrowing is made at the option of the DI. Repayment pursuant to a call or like provision vesting control of the time of repayment in the DI or an AFN, or the existence of unexercised options to renew, extend or continue the borrowing at the time of repayment, will be deemed to result in repayment at the option of the DI. (i) Preprogram guarantee of AFN borrowing. Repayment by a DI of an AFN borrowing, pursuant to a guarantee made prior to January 1, 1968, is au- thorized by § 1002(a)(1). A transfer of capital by the DI to an AFN to enable the AFN to repay a borrowing is similarly authorized, if the borrowing was guaran- teed prior to the effective date. For the purposes of § 1002(a)(1), a guarantee will be considered to have been made prior to the effective date if it was exe- cuted prior to the effective date, even though the AFN might not have actually made its borrowing until after the effec- tive date. Renewal of such guarantee or execution of a new guarantee in connec- tion with the same borrowing of the AFN or the refinancing thereof for which the first guarantee was executed will not be considered a new guarantee. Example 17. DI has an AFN (C) in Sched- ule C. On September 1, 1967, C borrowed $300,000 from a foreign bank for a term of 3 years, repayment of the borrowing being guaranteed by DI on the same date. For 1970 DI elects § 504(a) with a zero his- torical allowable in Schedule C. On Au- gust 31, 1970, when the loan becomes due, DI is called upon under the guarantee to repay the loan, plus $20,000 in accrued un- paid interest, C itself being unable to make repayment. DI makes repayment as de- manded. Repayment of the borrowing plus accrued interest in the aggregate of $320,- 000 is authorized by § 1002(a) (1) regardless of the fact that no positive direct investment is authorized to- DI under Subpart E during 1970 in Schedule C. (rT Repayment of AFN bank borrow- ing made or committed prior to Janu- ary 1, 1968. A transfer of capital is au- thorized if made in repayment of, or to enable an AFN to repay, a borrowing by such AFN from a bank made prior to January 1, 1968, or a borrowing by such AFN from a bank made on or after January 1, 1968, pursuant to a fixed loan commitment or line of credit established prior to such date or pursuant to any re- newal or extension thereof. Such repay- ment is authorized, however, only if the liquid assets of the AFN are not suffi- cient to repay the borrowing at maturity and if the AFN has made every reason- able effort to refinance the borrowing on terms generally available to com- panies of similar size and financial posi- tion. If, on or after January 1, 1968, the amount of such pre-January 1, 1968, fixed loan commitment or line of credit is increased by 10 percent or more, a new fixed loan commitment or line of credit is deemed to have been established at the time of the increase in -an amount equal to the amount of the increase (see § 1002(a) (2) ) ; repayments under the new fixed loan commitment or line of credit are not authorized by § 1002(a) (2) but may, if the applicable certifica- tion requirements are complied with, be authorized by § 1002 (a)(1) or (a)(5). If an AFN made a pre-January 1, 1968 borrowing from a bank and such borrowing was also guaranteed prior to January 1, 1968, the repayment will be generally authorized under § 1002(a) (1), rather than under § 1002(a)(2). If, however, the borrowing by the AFN was made prior to January 1, 1968, and the guarantee was made after January 1, 1968, § 1002(a)(2) will apply, unless DI, at the time of the guarantee, filed a cer- tificate pursuant to General Authoriza- tion No. 1. Example 18. DI has an AFN (C) in Sched- ule C. On September 1, 1967, C borrowed $300,000 from a foreign bank (F) for a term of 3 years. Repayment of the borrowing was not guaranteed by DI, but DI repaid the principal and accrued interest of $320,000 voluntarily on August 31, 1970, when the loan became due. At the time of such re- payment, C had liquid assets which were just sufficient to meet its current operating expenses, and C had diligently, though un- successfully, attempted to refinance the bor- rowing with F and with other foreign lend- ers. The repayment by DI is authorized by § 1002(a) (2). Example 19. DI has an AFN (C) in Sched- ule C. On December 1, 1967, C entered into a revolving credit agreement with a foreign bank (F) pursuant to which C could bor- row up to $1 million over a period ending November 30, 1970. Borrowings under the agreement are to be made against notes with maturities of 90 days which can be renewed within the overall period of the agreement. On January 15, 1968, C took down the entire $1 million and the note was rolled- over until November 30, 1970, at which time the outstanding indebtedness, plus $50,000 in accrued interest, became due. At this time, C had liquid assets which were sufficient to repay only $300,000 of the amount due and C was unable, after diligent effort, to refinance the balance with F or with other foreign lenders. Accordingly, the remaining $750,- 000 due was paid by DI on November 30, 1970. The payment by DI to F of $750,000 is authorized by § 1002(a) (2) . Example 20. On September 1, 1967, an AFN of DI entered into a revolving credit agree- ment under which AFN could borrow up to $1 million, and AFN immediately took down the entire amount. On September 20, 1968, the amount available to AFN under the revolving credit agreement was increased to $1,500,000, and AFN borrowed the additional $500,000 in October 1968. As a result, a new $500,000 line of credit is deemed to have been established on September 20, 1968. and re- payment by DI of any part of the additional $500,000 borrowing will not, therefore, be authorized by § 1002(a) (2) but would be authorized by § 1002(a) (5) if DI had guar- anteed the additional $500,000 borrowing and had complied with the certification require- ments of § 1002(b) of Subpart J. (iii) Repayment of AFN borrowing pursuant to guarantee made in the pe- riod January 1, 1968, through June 9, 1968. Repayment by a DI of an AFN bor- rowing, pursuant to a guarantee made on or after the effective date through June 9, 1968, is authorized by § 1002(a) (1) , if the DI filed a certificate described in § 2(a)(1) of General Authorization No. 1. A transfer of capital by the DI to REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7. 1970 58 RULES AND REGULATIONS an AFN to enable the AFN to repay such borrowing is similarly authorized. Section 2(a) (1) of General Authoriza- tion No. 1 required the DI to state that the DI "has no reason to believe, under existing circumstances, that the affil- iated foreign national will be unable to pay or otherwise satisfy such indebted- ness without resort to performance un- der the guarantee * * *." Although, should the DI be called upon to repay the AFN's borrowing pursuant to the guarantee, positive direct investment would be authorized by § 1002(a)(1) even if in excess of the amount authorized to the DI in the year of repayment, the Office may inquire into the good faith of the statement made by the DI in its certificate. Example 21. DI elects to be governed by § 503 during 1969. On March 15, 1968, DI executed Its guarantee of payment of princi- pal and interest under its AFN's 1-year note in the principal amount of $2 million, ex- ecuted that same day. DI filed a General Authorization No. 1 certificate, based upon the belief that AFN could renew the borrow- ing at the time that it came due. During 1968, the AFN exeprienced financial diffi- culties, the market for AFN's products diminished, and DI, at the beginning of 1969, was forced to discontinue the AFN's opera- tions. DI therefore repaid the $2 million, pursuant to its guarantee, on the maturity date of the note. The transfer of capital in repayment resulted in positive direct invest- ment in excess of $1 million, but the entire amount of positive direct investment at- tributable to repayment of the borrowing is authorized by § 1002(a) (1). Upon inquiry by the Office into the basis for DI's statement in the certificate, DI may offer as an explana- tion the changed circumstances which were beyond its control. (iv) Repayment of a long-term foreign borrowing made prior to January 1, 1968. Repayment of a long-term foreign bor- rowing (other than a repayment result- ing from conversions of debt into equity as described in § 1002(a) (3) ) made prior to the effective date is authorized by § 1002(a) (4). Example 22. In 1967, DI purchased all of the stock of a United Kingdom corporation from an unaffiliated foreign national. The purchase price was $5 million, $1 million being paid in cash at the closing and the balance being payable (together with interest of $480,000) 3 years from the date of closing. The $4 million balance constitutes a long- term foreign borrowing and payment of such balance in 1970 is authorized by § 1002(a) (4). Payment of the $480,000 in interest does not constitute a transfer of capital and thus does not require authorization (see § 312(c) (8)). (v) Repayment of a long-term for- eign borrowing made in the period from January 1, 1968 through June 9, 1968. Repayment of a long-term foreign bor- rowing (other than a repayment result- ing from conversions of debt into equity as described in § 1002(a) (3) ) made from the effective date throuh June 9, 1968, is authorized by § 1002(a) (4), provided that the DI filed a certificate described in § 2(b) of General Authorization No. 1. Section 2(b) of General Authorization No. 1 required the DI to state that it "has reason to believe that, under existing circumstances, the borrowing will ulti- mately be repaid or satisfied from sources outside the United States." Example 23. On March 15, 1968, DI made a long-term foreign borrowing from a foreign bank, the proceeds of which were $2 million. DI gave the bank its note with an original maturity of 12 months and filed a General Authorization No. 1 certificate In the belief that it could either renew the note when it became due or repay the borrowing with pro- ceeds of another long-term foreign borrow- ing. DI immediately loaned all of the proceeds to a Schedule C AFN. During 1968, the AFN experienced financial difficulties, the market for AFN's products diminished and DI, at the beginning of 1969, was forced to discontinue, the AFN's operations. DI was unable to renew the note or refinance the long-term foreign borrowing from another foreign lender, and DI repaid the borrowing from its funds in the United States. The transfer of capital in re- payment of the borrowing resulted, at the end of 1969, in positive direct investment in excess of DI's Schedule C allowable and was authorized by § 1002(a) (4) . Upon inquiry by the Office into the basis for DI's statement in the certificate, DI may offer as an explanation the changed circumstances beyond its con- trol. (vi) Repayment through conversion of debt obligations into stock of DI. Repay- ment by reason of the delivery of equity securities of the DI to holders of debt obligations of the DI (including an inter- national finance subsidiary of the DI) or of debt obligations issued by an AFN, pursuant to conversion or similar rights, is authorized by § 1002(a) (3) . No certifi- cate is required to be filed in order to authorize such repayment, regardless of when the borrowing was made. A certifi- cate must be filed, however, in order to provide authorization for cash payment of principal upon maturity of a converti- ble debenture offering, under § 1002(a) (5) and (6), since § 1002(a) (3) does not authorize such cash repayment. For purposes of § 1003, a transfer of capital resulting from a repayment by conversion is deemed to have been made in year immediately following the year in which the conversion or similar rights are exercised. Example 24. In February 1968, an interna- national finance subsidiary of a DI sold $20 million of 12-year debentures in a public offering, the proceeds of which qualify as long-term foreign borrowing proceeds under § 324. The debentures are convertible into common stock of DI commencing 6 months from the date of issue. The proceeds of the debentures were invested in incorporated AFNs of DI in Schedule A, where DI, during 1968, was authorized under § 504 to make positive direct investment of $3 million. During 1968, DI delivered $5 million worth of its common stock (in aggregate market value at the time of delivery) to holders of the debentures as a result of the con- version .of $3,500,000 in principal amount of the debentures. Such delivery resulted in a $3,500,000 repayment of the borrow- ing in 1968 (i.e., a transfer of capital to Schedule A during 1968 which is deemed to be made the following year for purposes of § 1003) . During the same year, DI made addi- tional positive direct Investment of $3 mil- lion in Schedule A, which was authorized by 5 504(a)(1). The positive direct investment resulting from delivery of the stock was au- thorized under § 1002(a) (3). Pursuant to § 1003, DI's Subpart E allowables are reduced by $3,500,000 In 1969. Example 25. In November 1968, a Luxem- bourg AFN of DI (L) sold $20 million of 12- year debentures In a public offering. Attached to the debentures were warrants entitling the holder to purchase a certain number of shares of DI's common stock at a certain price. A holder of the warrants may also exchange a debenture, upon presentation of the warrant, for common stock of DI. DI's independent financial counsel valued the warrants at $2 million (which valuation was acceptable to OFDI) , and DI recognized a transfer of capi- tal to L in that amount in connection with issuance of the debt and warrant package. During 1969, an aggregate principal amount of $3 million of debentures was presented along with the warrants, and DI issued com- mon stock in exchange therefor. The ex- change constitutes the satisfaction of an AFN debt obligation, resulting in an addi- tional transfer of capital under § 312(a) (6) in the principal amount of the debt surrend- ered ($3 million). Under 5 1002(a)(3), the transfer of capital is deemed to be made in the year following exchange, so that DI's Schedule C allowable is not reduced under § 1003 until 1970. (vii) Guarantee made on or after June 10, 1968. Repayment by a DI of an AFN borrowing, pursuant to a guarantee made on or after June 10, 1968, is au- thorized by § 1002(a)(5), provided that the DI filed a certificate described in § 1002(b). A transfer of capital by the DI to an AFN to enable the AFN to repay such borrowing is similarly authorized. Section 1002(b) requires the DI to state that it has reason to believe either that it will make no transfers of capital in repayment of the AFN borrowing within 7 years of the date of the guarantee, or, if it does make transfers of capital in re- payment of the borrowing within the 7- year period, positive direct investment resulting therefrom, if any, will be au- thorized by the DI's Subpart E (or M) allowable in the appropriate scheduled areas. Example 26. During 1968, DI had § 504 historical allowables of $750,000 in Schedule B and $1,250,000 in Schedule A. DI had two AFNs in Schedule B: F and X. F had existed for a number of years and had maintained a substantial level of earnings for the past 3 years. X had been organized in 1967 and had lost money in that year, but DI expected X to break even in 1968 and perhaps have small earnings in 1969. On July 1, 1968, DI negoti- ated an overdraft facility for X from a foreign bank, pursuant to which X could make over- drafts of up to $1 million. The term of the facility was 1 year, and DI guaranteed repay- ment of any amount outstanding at the end of that year. DI filed a certificate under § 1002(b) stating that DI had reason to be- lieve that no transfers of capital would be involved in repayment of the guaranteed bor- rowing, because renewal of the overdraft fa- cility was anticipated until such time as X would have the financial resources to be able to repay the borrowing itself. DI had reason to believe that, should X not be able to repay at any time, F would be able to loan funds to X out of its substantial cash reserves. Through the remainder of 1968, X and F encountered unprecedented business reverses, causing X to operate again at a loss, and re- sulting not only in a loss for F, but also ne- cessitating substantial invasion of capital reserves. During 1968, X took down the full $1 million under the overdraft facility. Dur- ing June 1969, the bank Indicated that It would not renew the overdraft facility for $1 million, but only for $500,000. DI at- tempted and failed to secure financing from REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 59 other sources to refinance the $500,000. There- fore, on June 30, 1969, DI repaid $500,000 to the bank pursuant to the guarantee. This repayment was authorized by § 1002(a)(5), and the positive direct investment resulting therefrom had the effect, pursuant to § 1003, of reducing DI's Schedule B historical allow- able for 1969 to $250,000. If OFDI should in- quire into the inability of DI to perform ac- cording to its reasonable expectations at the time of filing the certificate, DI may offer the unforeseen, changed circumstances as an ex- planation. (viii) Repayment of long-term foreign borrowing made on or after June 10, 1968. Repayment of a long-term foreign bor- rowing (other than a repayment result- ing from conversions of debt into equity as described in § 1002(a) (3) ) made on or after June 10, 1968, is authorized by § 1002(a) (6) if the DI filed a certificate described in § 1002(b). Section 1002(b) requires the DI to state that it has reason to believe either that (a) no transfers of capital will be in- volved in repayment of the long-term foreign borrowing within 7 years of the date of the borrowing, or (b) if transfers of capital are made in repayment of the borrowing within the 7-year period, posi- tive direct investment resulting there- from, if any, will be authorized by the DI's Subpart E (or M) allowable in the appropriate scheduled area. Example 27. On September 1, 1968, DI made a long-term foreign borrowing of $5 million from a foreign bank, giving the bank its 12- month note. DI immediately loaned the funds to its Schedule C APN (C). Although the terms of the note did not make it renew- able, DI was assured by the lender that, if there would be no material change in the DI's business and financial condition and in the prevailing money market, it would give favorable consideration to requests by the DI to roll-over the loan until August 31, 1975. Based on existing circumstances, DI did not anticipate any material adverse change in its business or financial condition and intended to request renewal to August 31, 1975. In this situation, DI filed a certificate under § 1002(b) (1). During the remainder of 1968 and in 1969, however, both C and DI suffered unexpected business" reversals, and in August 1969, the lender indicated that it would renew the note only to the extent of $2,500,000. DI attempted and failed to find financing from other sources, and therefore repaid the borrowing to the extent of $2,- 500,000 from U.S. sources on August 31, 1969. The positive direct investment resulting therefrom is authorized by § 1002(a) (6). If OFDI inquires into the inability of DI to perform according to its reasonable expecta- tions at the time of filing the certificate, DI may offer the unforeseen and changed circumstances as an explanation. § B1002-2 Standard Certificate Form FDI-106. All certificates filed on or after June 10, 1969 must be made on Standard Certificate Form FDI-106. (Prior to June 10, 1969, the format of submission was immaterial so long as the certifica- tion contained all information and statements required by Subpart J.) A revised Standard Certificate Form FDI-106 was issued by OFDI on Au- gust 6, 1970, applicable to all borrowings made on or after May 1, 1970. However, it is not necessary for DIs to file new certificates for borrowings certified after May 1, 1970, and before revised Form FDI-106 was issued. The certificate must be delivered to OFDI within 10 days after the date of a borrowing by the DI, or the date of DI's guarantee of an AFN borrowing, as the case may be. For purposes of computing the 10-day period, the date of a borrow- ing by the DI is fixed according to the rules of § 1002(e)(1). The date of a guarantee is not simply the date on which DI executes the guarantee or when the last act necessary to complete a deposit, pledge or hypothecation has taken place. Rather, the date of the guarantee of an AFN borrowing is the first date on which both the guarantee and the borrowing are in existence, un- der § 1002(e) (1). Thus, if on January 1 DI executes a written repayment guar- antee with respect to AFN borrowings up to $1 million and the AFN borrows only $500,000 on that date, then borrows another $500,000 on June 1, DI may file two certificates, each covering a $500,000 guarantee of an AFN borrowing, the first by January 10, and the second by June 10. Alternatively, DI could have filed a single certificate as to the full $1 million on or before January 10. As noted above, however, if a DI exe- cuted a guarantee of an AFN borrowing prior to January 1, 1968, but the AFN did not actually borrow until after that date, OFDI will not require a certificate to have been filed in order for repay- ment to be authorized. Also, if a DI exe- cuted a guarantee in the period Janu- ary 1 through June 9, 1968, but the AFN borrowing took place on or after June 10, 1968, the DI is not required to replace its General Authorization No. 1 certificate with a Subpart J certificate. The following sections explain the substantive requirements of Form FDI- 106 (as revised Aug. 6, 1970) except for those portions that are self-explanatory. For explanation of Form FDI-106 in effect for borrowings made prior to May 1, 1970, see 1969 General Bulletin § B1002-2. (i) Item I. The certificate should be filed only by the DI (or a duly authorized representative). If an international fi- nance subsidiary of a DI (see § 323) makes a borrowing guaranteed by the DI, the borrowing is treated as if made by the DI itself and only one certificate need be filed. A guarantee by one AFN of a borrowing by another AFN would like- wise require a certificate filing only by the DI. A DI that becomes obligated to repay long-term foreign borrowing, previously certified by another DI, in connection with an acquisition described in § 312(c) (1) must file a new Standard Certificate Form FDI-106 in order to authorize re- payment of such borrowing under Sub- part J. (See § B312-18.) When a shareholder guarantees a bor- rowing by a principal DI, a single certi- ficate should be filed by the principal DI on the basis of its allowable, unless the principal DI is an affiliate of the share- holder or unless the shareholder has con- sented to an election under § 906(b) (2). Transfers of capital pursuant to such guarantee that result in positive direct investment will reduce the principal DI's allowables as provided in § 1003. If the principal DI is an affiliate of the share- holder guaranteeing the borrowing, the member of the affiliated group filing re- ports under § 602 should file the certi- ficate. (See § 907(d).) If the sharehold- er has consented to an election under § 906(b) (2), the shareholder (and any other consenting shareholder guarantee- ing the borrowing) should file a single certificate. Positive direct investment at- tributable to transfers of capital made by a consenting shareholder pursuant to such guarantee will reduce the allowables of such consenting shareholder in accordance with the provisions of § 1003. When an indirect owner guarantees borrowing by an AFN of the principal DI, the principal DI should file a single cer- tificate, whether or not the election un- der § 906(b)(1) has been made, unless the principal DI is an affiliate of the shareholder. In this case, the member of the affiliated group filing reports under § 602 should file the certificate. Positive direct investment attributable to trans- fers of capital made pursuant to such guarantee will reduce the allowables of the principal DI. (ii) Item II. DI should check the ap- propriate box as to whether the certif- icate relates to (a) "foreign borrowing", (b) a guarantee by DI (or an AFN) of a borrowing by an AFN, or (c) a guarantee by DI (or an AFN) of a borrowing by an overseas finance subsidiary governed by Subpart N. If the certificate relates to a borrowing by an AFN (or an over- seas finance subsidiary) that is guaran- teed by another AFN of the DI, the name of the guarantor AFN should also be in- cluded, along with the name of the bor- rower AFN and the country where the borrower AFN is located. (iii) Item IV. In entry (a)(1), the term "credit facility" refers to an ar- rangement with a lender (such as a line of credit or revolving credit arrange- ment) whereby funds may be taken down from time to time over a specified period up to a stated maximum aggre- gate amount, as described in § 1002(e) (3) . In such cases, a DI may file a single certificate with respect to such credit facility, instead of filing separate certifi- cates for each borrowing by the DI or guarantee of an AFN's borrowing pur- suant to the arrangement involved. (Although § 1002(e)(3) provides that a certificate with respect to a credit facility should be filed on or prior to the date of the first takedown, OFDI will treat such certificates as timely filed if they are de- livered within 10 days after the first takedown.) A credit facility will be certi- fied only when first made or at the time of its renewal. A DI must file a new certi- ficate upon expiration of a credit facility and the execution of a new credit facility, but only to the extent that borrowings pursuant to the credit facility are not outstanding at the time of renewal. If borrowings are outstanding, the renewal of the credit facility is simply a renewal of the borrowing, and no new certificate need be filed. (The renewal or refinanc- ing, as described in § 1002(e) (2), of a takedown under a credit facility or of an REPRINTED FROM FEDERAL REGISTER, VOL. 35. NO. 195— WEDNESDAY, OCTOBER 7, 1970 60 RULES AND REGULATIONS isolated borrowing need not be certified at that time, since the renewal or re- financing is not the making of a new borrowing or guarantee of an AFN bor- rowing (see § 324(b) (1) .) Entry (a)(2) deals with a new bor- rowing or a single takedown pursuant to a credit facility if the DI did not file a certificate with respect to the entire credit facility, but is filing separately for each separate takedown pursuant to a credit facility. In a few isolated instances, however, such as where DI desires to change the statement made in a certificate or where changed or addi- tional facts provide a more favorable basis for making a certificate, the DI may desire to file a second certificate for a single takedown under a credit facility for which a certificate has previously been filed. In that event, (a) (2) should be checked. Example 28. On September 1, 1970, DI en- ters into a revolving credit arrangement with a foreign bank pursuant to which DI may borrow up to $5 million through August 31, 1974. Borrowings under the arrangement are to be made against notes with maturities of 180 days, renewable within the overall period of the arrangement. Funds borrowed under this arrangement are to be invested by DI in a Schedule A AFN, where the DI has a his- torical allowable of $7,500,000. DI believes, as of September 1, 1970, that positive direct investment in Schedule A in 1974, when all outstanding indebtedness will be paid in full, will not exceed $6,500,000. In this situation, DI may file a single Form FDI-106 on the basis that all repayments made within 7 years from the date of each borrowing un- der the revolving credit arrangement will be authorized by § 504. In completing Item IV of Form FDI-106, DI should check (a) (1), entering $5 million as the amount of the credit facility in IV(b) and September 1, 1970 as the date in IV(c) . On August 31, 1974, consider the follow- ing alternative possibilities: (a) All borrowings made under the ar- rangement have been repaid in full. DI and the bank renew the revolving credit arrange- ment on the same terms for an additional 2- year period, ending August 31, 1976. Funds borrowed under the arrangement as renewed are also to be invested in Schedule A AFNs. In this situation, DI must file a new certifi- cate stating the belief that all repayments made within 7 years from the date of each borrowing will be authorized by § 504. DI will check (a)(1) of Item IV and will also enter the amount of the credit facility ($5 million) and the date, August 31, 1974. (b) The arrangement is renewed, with $5 million of borrowings under the prior arrangement still outstanding. The funds to be borrowed under the renewed arrangement are to be used to refinance the outstanding indebtedness. Since, by virtue of the pro- visions of § 1002(e) (2), funds borrowed un- der the renewed arrangement to refinance existing indebtedness will not constitute new borrowings, DI is not required to file any additional certificates because of the renewal of the arrangement. (c) The arrangement is renewed, with $3 million of borrowings under the prior ar- rangement outstanding. Thus, $3 million of borrowing under the renewal will be used to refinance outstanding indebtedness, and does not constitute a new borrowing. The remain- ing $2 million will constitue a new borrow- ing, when DI takes down that amount. DI plans to invest the $2 million in the Sched- ule A AFN, so that DI may file a single cer- tificate with respect to the $2 million bor- rowing it may make under the renewal agree- ment. If DI files a single certificate, entry (a)(1) should be checked. The amount of the arrangement is $5 million and the date is August 31, 1974. However, DI will certify only to $2 million of borrowings ($5 million less $3 million) . Entry (a) (3) is for a borrowing con- stituting a refinancing of a foreign bor- rowing or long-term foreign borrowing previously certified. Although a refinanc- ing borrowing as described in § 324(b) (l)need not be certified, there may be instances when a foreign lender may in- sist on certification. Entry (a)(4) should be checked if Item II (b) or (o was checked. Entry (b) should show the principal amount of the transaction being certi- fied. If an offering with warrants attached is made by a DI, a certain por- tion of the funds or other property received from the offering will be attrib- utable to sale of the warrants and, there- fore, will not constitute proceeds of long-term foreign borrowing. In such case, the DI should indicate the value of the warrants, based upon a valuation by one or more of the principal underwriters or by DI's independent financial counsel. (OFDI reserves the right to review the reasonableness and accuracy of any such valuation.) The value of the warrants should be deducted from aggregate prin- cipal amount of the bonds or debentures, and the difference is the amount of po- tential repayment that must be certi- fied. (See § 324.) If such an offer is made by an AFN of DI, attachment of war- rants will not have an effect on the amount of the borrowing. However, DI must reflect, on the appropriate Form FDI-102 or Form FDI-102F, a trans- fer of capital from DI to AFN in the amount of the value of the warrants. The DI must certify with respect to poten- tial repayment of the full aggregate principal amount of the debt. Entry (c) should show the date of the transaction being certified. See § 1002 (e) (1) and §§ B1001-1 and 1002-2 above. (iv) Item V. DI must check the box preceding the category of § 324(a)(1) under which a borrowing qualifies as a foreign borrowing. (v) Item VI. Item VI follows the struc- ture of § 1002(b) . Statement (a) restates § 1002(b)(1), and Statement (b) re- states § 1002(b) (2). In order to obtain authorization to repay a borrowing de- scribed in § 1002(a) (5) or (6), a DI must make one of the two statements by checking the appropriate box opposite (a) or (b). With respect to either state- ment, a DI must check at least one of the boxes. If none of the premises ex- pressly stated under Statement (a) or (b) corresponds to the particular facts of the transaction, the DI must check the box marked "Other" and write the particular reason for making the statement. In order to make Statement (a) , a DI must have reason to believe, based on all the facts and circumstances existing at the time the certificate is delivered to OFDI, that there will not be any repay- ment of the borrowing within 7 years of the date of the borrowing, or the date of the guarantee if the borrowing is by an AFN. For purposes of determining the 7-year period when a guaranteed borrowing by an AFN is involved, the date of the guarantee of the borrowing is considered to be the first date when both the guarantee and the borrowing by the AFN are in existence, e.g., when the guarantee has been executed and the borrowing has been taken down. As to borrowings made under a credit fa- cility, the 7-year period is computed separately for each borrowing made under the facility. When making Statement (a), a DI need consider only whether repayment of the borrowing can be postponed for a period of 7 years. Whether positive direct investment resulting from repay- ment at that time will be authorized by the DI's Subpart E allowables is irrele- vant. For example, a DI that has only a § 507 allowable may make the statement with respect to a $10 million borrowing made in 1970, even though repayment in 1977 would exceed the present § 507 al- lowable. (When the borrowing is repaid in 1977, § 1003 requires that positive di- rect investment resulting from repay- ment will be a first charge against Sub- part E allowables.) Similarly, even though a DI would be able to offset any positive direct investment (e.g., by al- locating proceeds of other long-term foreign borrowing) resulting from a re- payment within 7 years, DI may not certify on the basis of Statement (a) . In such case, DI should use Statement (b) . Statement (b) may be made if a DI cannot make Statement (a). In order to make Statement (b) a DI must have reason to believe, based on all the facts and circumstances existing at the time the certificate is delivered to OFDI, that any repayment within 7 years of the bor- rowing either will not result in positive direct investment in Schedules A, B, or C, or that if such repayment does result in positive direct investment, such posi- tive direct investment will be authorized during the year when repayment is made by the DI's Subpart E (or M) allowables in the scheduled area in which the trans- fer of capital under § 312(a) (6) or (7) is incurred. Upon the expiration of the 7-year period, any repayment made by DI will be authorized by § 1002, even if resulting in positive direct investment in excess of Subpart E (or M) allowables so long as DI has satisfied the conditions of Statement (b) during the 7 -year pe- riod. When making such statement, a DI may assume that the §§ 503 and 507 al- lowables will continue to be tire amount in effect during the year when the cer- tificate is filed. Thus, a DI filing during 1970 may assume that the § 503 allow- able will continue, in future years, at $1 million and that § 507 allowables will be $1 million for Schedules B and C and $4 million for Schedule A. Similarly, a DI may assume that historical allowables will continue, in future years, at the amounts set by § 504 (a) and (c) in the year of filing, that for purposes of § 504(b) earnings allowables will con- tinue to be based on 30 percent of earn- ings in the appropriate prior year or years, and that the § 506 incremental earnings allowable will continue to be REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7. 1970 RULES AND REGULATIONS 61 computed in the same manner. On the other hand, where the transaction in- volved is a borrowing by an AFN with the DI's guarantee, DI must make a rea- sonable estimate of future AFN earnings, based on facts and circumstances exist- ing at the time the certificate is filed. When filing each certificate with re- spect to a borrowing, the DI must also take into consideration the projected use of allowables in the year when repay- ment falls due. For example, a DI elect- ing to be governed by § 503 during 1970 and expecting to use the § 503 allowable through 1972 could not file certificates in 1970 containing Statement (b) with re- spect to two borrowings, each for $1 mil- lion and each requiring full principal re- payment in 1972. Basing certification on the availability of a certain allowable in a future year, however, does not bind the DI to elect such allowable under § 502 for the year in question. The following examples illustrate situ- ations in which the assurances contained in Statement (a) would be appropriate: Example 29. DI borrows $1 million from a foreign bank on September 1, 1970, giving the bank a note maturing on September 1, 1977. The DI may file a certificate under § 1002(b) by checking the box opposite Statement (a) (1) of Item VI on Form PDI-106, since no principal payments are required within 7 years. Example 30. On September 1, 1970, DI's International finance subsidiary issues to non-Canadian foreign nationals debentures in the principal amount of $10 million, ma- turing on March 1, 1977. DI intends to re- finance the borrowing on March 1, 1977 by making a 6-month borrowing from a foreign bank. DI may certify under § 1002(b) (1) by checking the box opposite Statement (a) (2) of Item VI on Form FDI-106, because DI be- lieves that the borrowing can be refinanced for a total period of 7 years. Example 31. DI's sole AFN in Schedule C borrows $1 million from a foreign bank on September 1, 1970, giving the bank its note maturing on August 31, 1972. The note is guaranteed by DI. DI has reason to believe, under existing circumstances, that the AFN will have sufficient financial resources in 1972 (generated by depreciation, earnings, and borrowings) to repay the loan and to pay all dividends required to satisfy limita- tions on positive direct investment imposed by the regulations. (See § 1002(c) (3) .) DI may file a certificate under § 1002(b)(1) by checking the box opposite Statement (a) (3), because DI does not anticipate being called upon to make any principal repayments of the borrowing pursuant to the guarantee. The following examples illustrate sit- uations in which the assurances con- tained in Statement (b) would be appro- priate : Example 32. DI borrows $500,000 from a foreign bank in September 1970, using the proceeds to purchase all voting stock of a company in Schedule A. The borrowing is repayable in 1972, and DI does not anticipate having any allowable under § 504 or § 506 during 1972. The DI believes, under existing circumstances, that the acquired company will earn $40,000 in 1972, all of which will be reinvested, but (apart from repayment of the loan and such reinvested earnings) does not intend to make any other positive direct investment in excess of $250,000. In this sit- uation, DI may file a certificate under § 1002 (b) (2), checking Statement (b). Repayment of the $500,000 borrowing in 1972, plus the $40,000 of reinvested earnings in 1972, plus $250,000 of other positive direct investment would result in positive direct investment of $790,000 during that year, all of which would be authorized by § 503 or § 507. Example 33. During 1970, DI has historical allowables of $400,000 in Schedule C, $5 mil- lion in Schedule B and $10 million in Sched- ule A. The § 504(a) historical allowable is elected and, under the upstream provision of §504(c)(l), DI has a total allowable in Schedule C of $600,000 for 1970, based on 1969 annual earnings of DI's Schedule C AFNs of $2 million. During September 1970, DI makes long-term foreign borrowing of $1 million which will be repaid in 1972. DI intends to invest the $1 million in Schedule C AFNs. DI has reason to believe, based on existing circumstances, that the Schedule C AFNs will have annual earnings in 1971 of $4 million, giving DI a Schedule C allowable during 1972 of $1,200,000. DI further has reason to believe that the AFNs, in 1972, will reinvest no more than $200,000 of their earn- ings. Under these circumstances, DI may file a certificate under § 1002(b) (2) , checking Statement (b) of Item VI on Form FDI-106, because there is reason to believe that repay- ment of the borrowing in 1972 will be au- thorized within the Schedule C allowable for that year. (Note that DI cannot base certifi- cation on the allowable available in Schedule B or A, even though such allowables would be reduced in 1971 (pursuant to § 1003) if the Schedule C allowable is not sufficient to absorb the charge when the debt is repaid.) Example 34. For 1970, DI elects the histori- cal § 504(a) allowable, with a Schedule B allowable of $1,200,000. During 1970, DI's Schedule B AFNs have earnings of $2 million, all of which DI desires to reinvest (resulting in positive direct investment of $2 million). DI makes long-term foreign borrowing in October 1970 of $800,000, which will be repaid in November 1971, and allocates the proceeds to positive direct investment in Schedule B at the end of 1970. DI has reason to believe that the AFNs in Schedule B will again have $2 million of earnings during 1971, but that they will be able to declare $800,000 of dividends. DI further plans, during 1971, to liquidate certain Schedule B holdings, which liquidation will result in a negative net trans- fer of capital during 1971 of $900,000. Under these circumstances, DI may file a certificate under § 1002(b) (2), checking Statement (b) of Item VI on Form FDI-106, because there is reason to believe that positive direct in- vestment resulting from repayment of the borrowing in 1971 will be authorized under the Schedule B allowable. § B1002— 3 Certification with respect to convertible debt. Section 1002(c)(2) provides that, un- der certain circumstances, a DI may exclude potential transfers of capital re- sulting from conversion of debt instru- ments into equity securities of the DI in determining (for purposes of Subpart J) whether positive direct investment re- sulting from repayment will be author- ized by Subpart E (or M) allowables. No certificate is required with respect to positive direct investment resulting from the conversion itself (§ 1002(a) (3) ) . Ac- cordingly, § 1002(c) (2) is applicable to certification as to (i) repayment by a DI pursuant to guarantee of an AFN's con- vertible debt (under § 1002(a)(5)), (ii) cash repayment of a DI's convertible long-term foreign borrowing (under § 1002(a) (6) ), or (iii) repayment (under § 1002(a) (1) or (4)) of a borrowing unrelated to the convertible debt at a time such debt is outstanding. The effect of § 1002(c)(2) is that, in the stated circumstances, a DI may rely on future allowables and their availa- bility for cash repayment of borrowings, without having to take into considera- tion the potential charge to such allow- ables resulting from a conversion. For example, if a DI which elects § 503 has made a public offering of 20-year con- vertible debentures in principal amount of $20 million, and subsequently makes $1 million of long-term foreign borrow- ing to be repaid in 5 years, a § 1002(b) (2) certificate may properly be executed as to the $1 million borrowing notwith- standing that potential conversions of the outstanding convertible debt could use up DI's § 503 allowable for the year the $1 million borrowing is repaid (as- suming the conditions in the proviso to § 1002(c) (2) are satisfied). On the other hand, if convertible debt fails to meet either of the two conditions in the proviso to § 1002(c)(2), potential conversions must be taken into account when filing certificates. If the convertible debt does not have an original maturity of 7 years, potential charges to positive direct investment resulting from conver- sions must be considered by the DI in determining whether sufficient allow- ables will exist during any year to au- thorize cash retirement of the convert- ible debt or of any other borrowing by the DI or an AFN. Similarly, potential charges against allowables must also be taken into account by the DI if a non- public debt issue is convertible within 3 years of the date of issuance. Potential charges against allowables resulting from conversion need not be taken into account, even if the debt is convertible within 3 years of the date of issuance, if the convertible debt is a public offering. The term "public offering" for pur- poses of the second condition in the pro- viso to § 1002(c) (2) means generally that at least half of the issue must be distrib- uted through normal investment banking channels abroad, or sold to foreign pur- chasers engaged in the business of deal- ing in securities, in a manner affording reasonable prospects of an effective sec- ondary market for the securities. If, in connection with a convertible debt issue, DI certifies under § 1002(b) (1) that no principal repayments will be made within 7 years, DI need not con- sider potential conversions even though the issue does not satisfy the proviso of § 1002(c) (2) . However, whenever DI files a certificate under § 1002(b) (2) , and con- vertible debt is outstanding that falls into either of the conditions of the pro- viso to § 1002(c) (2), potential conver- sions must be considered by the DI. Example 35. DI has no § 504 allowables. In September 1968, DI purchased all stock of a Brazilian corporation from an unaffiliated foreign national (X) in exchange for a $5 million debenture issue maturing in 10 years and convertible (in whole or in part) into common stock of DI commencing 3 years from date of issuance. Interest on the de- bentures is payable semiannually, but in the event of default on payment of any interest installment, X has the right to declare the entire principal sum to be immediately due and payable. However, DI was in good REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 62 RULES AND REGULATIONS financial condition and did not anticipate de- fault in interest payments. DI filed a certifi- cate under § 1002(b)(1), since no principal repayments are required to be made within 7 years from the date of issue. (Repayment by reason of conversion would be authorized by § 1002(a) (3), without regard to the Sub- part J certification requirements.) In 1970, DI desires to make long-term foreign borrow- ing of $4 million, to be repaid In 1972, and to allocate the proceeds thereof to positive direct investment In Schedule A. Without regard to any charge against the § 507(a) (2) allowable resulting from conversion of the debenture, DI may file a certificate with respect to the long-term foreign borrowing under § 1002(b) (2) if there is reason to be- lieve that the entire § 507(a) (2) allowable will be available to authorize repayment in 1972. Example 36. In 1968, DI made a public of- fering of $2 million principal amount of con- vertible debentures, maturing in 1988 and convertible after 6 months from the date of issue. The proceeds were immediately in- vested in Schedule C. DI filed a certificate under § 1002(b) (1) with respect to the bor- rowing. In 1970, DI makes a $5 million long- term foreign borrowing from a foreign bank, repayable at the rate of $1 million annually for the next 5 years, and DI allocates the proceeds thereof to Schedule C positive di- rect investment. In 1970, DI has a § 504(b) Schedule C allowable of $2,500,000, and has reason to believe that (except for any posi- tive direct investment resulting from con- version of the convertible debt) repayment of the bank loan can be accomplished within this allowable over the next 5 years. (DI ex- pects to have annual earnings of $6 million in Schedule C, to cause Schedule C APNs to declare dividends of $4,500,000 per year, and does not expect to make any positive net transfer of capital for the next 5 years.) DI does not have to make allowance for positive direct investment resulting from potential conversions of the debenture issue when analyzing its ability to file a certificate with respect to the bank borrowing under § 1002 (b)(2). Example 37. On September 1, 1970, DI publicly offers $20 million principal amount of debentures with maturity of 25 years, convertible into stock of DI at any time after 6 months from the date of issue. The offering qualifies as long-term foreign bor- rowing, and DI immediately invests the pro- ceeds in Schedule C, where DI has a historical allowable of $2 million. Under the underwrit- ing agreement, DI must make mandatory sinking fund payments to be used by a trustee to redeem debentures in the prin- cipal amount of $1 million in each of the years 1975 through 1993. Because original maturity of the debenture issue is only 5 years, and not 7 years, consideration must be given to whether the $1 million repayment of principal that will be charged to DI's Sched- ule C allowable during the years 1975-77, together with potential conversions, can be made within the allowable for that schedule. While DI cannot certify under § 1002(b)(2) in these circumstances, a certificate under 5 1002(b)(1) could still be executed if DI has reason to believe that any cash principal repayments or conversions in excess of the Schedule C allowable could be refinanced so that the full amount of the borrowing would have been continuously outstanding for at least 7 years. § B1003-1 Effect of transfers of capital in repayment of borrowings. Section 1002 provides that positive di- rect investment attributable to transfers of capital in connection with repayments of certain borrowings are generally au- thorized, subject to § 1003. Such repay- ments are authorized even though posi- tive direct investment resulting there- from exceeds a DI's available allowables during the year of repayment. However, to the extent DI has allowables, § 1003 requires that such allowables be reduced by the amount of the repayment. (The $4 million Schedule A supplemental al- lowable is reduced only to the extent the loan being repaid was used in connection with direct investment in Schedule A.) If the amount repaid exceeds the allowables available in the year of repayment, the excess will be carried over and charged against allowables in succeeding years until reductions equal the amount of re- payment. Accordingly, repayment of a borrowing is permitted but a DI's allow- ables are correspondingly reduced in the year of repayment and, if necessary, in succeeding years. The amount of positive direct invest- ment made by a DI under § 1002 is called the "repayment charge." The al- lowables elected by DI under Subpart E (and Subpart M, if applicable) are re- duced, but not to less than zero, until such reductions equal the repayment charge. Of the Subpart E allowables, the § 506 incremental earnings allowable is tho last to be reduced. Subpart M allow- ables are reduced after Subpart E allow- ables, unless the repayment charge is incurred in connection with the DI's foreign air transportation operations (see §§1301-1302), in which case the Sub- part M allowable is reduced first. Re- ductions of § 504 allowables in Schedule C are made first to § 504 (a) and (c) or (b), (d)(3), and (f)(3) (i), and then to § 504 (e) and (f)(3)(h). Section 1003(c) (1) provides that Sub- part E allowables are reduced first in the scheduled area where positive direct in- vestment was made under § 1002 and, to the extent the repayment charge exceeds allowables available for that scheduled area, then in Schedules C, B and A, in that order. If Subpart E allowables are insufficient to absorb the repayment charge, Subpart M allowables are then reduced. Section 1003(c)(5) deals with the re- duction of the § 507 allowables. It pro- vides that the $4 million Schedule A sup- plemental allowable (§ 507(a) (2)) will be reduced only to the extent that the DI has repaid a long-term foreign borrow- ing the proceeds of which were expended in Schedule A or were allocated to posi- tive direct investment in Schedule A, or to the extent that the DI has made pay- ments on a guarantee of a Schedule A APN borrowing or to enable a Schedule A AFN to repay its borrowing. To the extent that the repayment charge in any year exceeds all applicable Subpart E and M allowables, § 1003(d) provides that allowables in the following year or years are reduced in the same manner. However, a DI may elect under § 1003(d) not to have its § 507(a) (2) Schedule A supplemental allowable re- duced in any year by a carryforward (from 1969 or a subsequent year) of a repayment charge attributable to Sched- ule A. (i) The repayment charge. A repay- ment charge is incurred in the amount of positive direct investment resulting from transfers of capital enumerated in § 1002(a) (l)-(6), namely, (a) those to repay or enable the AFN to repay certain borrowings of the AFN; (b) those con- sisting of the delivery of equity securities of the DI upon conversion of certain debt obligations of the DI or an AFN; or (c» those made in repayment of long-term foreign borrowings of the DI. Although the repayment charge is gen- erally incurred in the year that positive direct investment is made, transfers of capital resulting from conversion of debt obligations are deemed (solely for pur- poses of § 1003) to occur in the year immediately following the year of con- version. (See § 1002(a)(3).) Repayment of a long-term foreign bor- rowing by a DI (including delivery of equity securities upon conversion) results in a transfer of capital to the scheduled area where the proceeds were expended or allocated at the time of repayment and with respect to which a deduction was taken under § 203(d), § 306(e), or § 313 (d) (1) . If proceeds of the borrowing were utilized to offset positive direct invest- ment in more than one scheduled area at the time of repayment, the transfer of capital resulting from repayment will be charged proportionally, based on the de- duction taken in each scheduled area. (See § 312(a) (7).) Note that when there is repayment of a long-term foreign bor- rowing that was not expended or allocat- ed, no transfer of capital will result. Transfers of capital to repay or to en- able an AFN to repay a borrowing made by by the AFN are charged against the DI's allowables in the scheduled area of the AFN. (ii) Reduction of allowables. Section 1003 (c) and (d) prescribe the manner in which allowables under Subparts E and M are reduced because of a repayment charge incurred pursuant to § 1002. A special rule applies to reduction of Schedule C allowables under § 504. Sec- tion 1003(c) (3) provides that the allow- ables authorizing positive direct invest- ment in Schedule C (§ 504 (a) and (c) or (b), (d)(3), and (f)(3)(D) are reduced before those authorizing reinvested earn- ings (§504 (e) and (f)(3)(h)). If DI has total losses in Schedule C during the year, the amount of such losses does not constitute an allowable under § 504(e) until the following year, at which time it would be subject to reduction under § 1003. Example 38. In 1970 DI elects § 504(b) with an allowable in Schedule C of $2 million. DI also has a carryforward from 1969 in Schedule C under § 504(d) (3) of $300,000 and a reinvested earnings allowable of $200,000 under § 504(f) (3) (ii) as a result of losses in Schedule C during 1968. During 1970 DI incurs a repayment charge of $2,400,000 in Schedule C. After making reductions as pro- vided by § 1003(c) (3), DI will have left only $100,000 of the reinvested earnings allowable under § 504(f) (3) (ii). A special rule also applies to U.S. -air carriers engaged in international air transportation. Section 1003(c)(4) pro- vides that where a transfer of capital resulting in a repayment charge is pri- marily related to operations in foreign REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 63 air transportation (as defined in § 1302 (a)), the Subpart M allowable shall be reduced first. If the repayment charge is not related to operations in foreign air transportation, the Subpart E allow- ables will be reduced first, in accordance with § 1003(c)(1). Example 39. In 1969, DI, a U.S.-flag air- line, has a foreign air transport allowable of $1 million and § 504(a) allowables of $500,000 in Schedule A, $600,000 in Schedule B and $400,000 in Schedule C. In 1969 DI repays a $1,500,000 borrowing made in connection with its operations in foreign air transportation, resulting in a repayment charge of $1,500,000 under §§ 1002 and 1003. First, DI's foreign air transport allowable is reduced to zero and the excess of $500,000 is charged against its § 504(a) allowables in Schedules C, B, and A, in that order. There- fore, DI's Schedule C allowable is reduced to zero and its B allowable is reduced to $500,000. The $500,000 allowable in Sched- ule A is not affected. Example 40. During 1969, DI repays a $1 million long-term foreign borrowing, the proceeds of which had been expended in Schedule A. Under § 1002, DI has made posi- tive direct investment in Schedule A of $1 million constituting the "repayment charge" for purposes of § 1003. DI's allowables under § 504(a), which is elected for 1969, are $600,000 in A, $300,000 in B and $300,000 in C. Under § 1003(c) (1), the Schedule A allow- able ($600,000) is first reduced to zero; then, to the extent the repayment charge exceeds the reduction in A, the excess reduces allow- ables first in C (by $300,000 to zero) and then in B (by $100,000 to $200,000). Therefore, in 1969 DI may make no positive direct invest- ment in C, no additional positive direct investment in A, and positive direct invest- ment in B is limited to $200,000. In 1970 the result would be the same. If DI had a § 506 incremental earnings allow- able in 1970, the incremental earnings allow- able would not be reduced because the DI's § 504 (a) and (c) allowables are sufficient to cover the repayment charge and § 1003 (c) (2) provides that the § 506 incremental earnings allowable is the last of the Subpart E allowables to be reduced. If, however, DI does not have a § 506 incremental earnings allowable in 1970, it would be to DI's advan- tage to elect the § 507 allowable for 1970. In such case, the repayment would reduce DI's Schedule A allowable under § 507(a) (2) from $4 million to $3 million, and there would be no reduction of DI's $1 million allowable in Schedule B/C. Example 41. During 1968, DI, with allow- ables of $2 million in Schedule A and zero in Schedules B and C, repaid a $1 million 1967 borrowing used to acquire all outstand- ing shares of a German corporation. Since the "repayment charge" was incurred during 1968 (see § 1003(a)), no reduction of any allowables could be made under the applica- ble 1968 regulations, which did not provide (as does § 1003(c)(1) of the 1969 and 1970 regulations) for reducing allowables in other scheduled areas. Although the $1 million repayment charge may be applied in subsequent years (under § 1003(c) (3) as in effect for 1968), only Schedule C allowables or the worldwide § 503, § 507(a)(1), or §506 allowables may be charged. Example 42. In 1970 DI's § 504(b) earnings allowable is $600,000 in Schedule C, $1 million in Schedule B and zero in Schedule A. DI's § 1302 (Subpart M) foreign air transport allowable is $700,000. DI also has a $200,000 § 506 incremental earnings allowable. During 1970 DI repays a long-term foreign borrowing, the proceeds of which had been expended in making a transfer of capital in the amount of $2,100,000 to construct a resort hotel in Schedule B. Assuming the repayment is au- thorized by § 1002, DI has incurred a repay- ment charge of $2,100,000 under § 1003, which first reduces DI's § 504(b) allowable in Sched- ules B and C to zero. DI's § 506 allowable is then reduced to zero, and the Subpart M allowable is reduced to $400,000. See § 1003 (c) (1) and (2). The § 506 incremental earnings allow- able is the last Subpart E allowable to be reduced under § 1003 (see § 1003(c) (2)). Example 43. DI elects to be governed by § 503 in 1970 and has a § 506 allowable of $100,000. DI makes a $1,050,000 repayment under § 1002. After the reductions under § 1003, DI has $50,000 of its § 506 allowable left. (See also Example 46 below.) In general, all allowables (including accrued carryforwards) for the year are reduced under § 1003(c) to the extent of the repayment charge. If the repayment charge exceeds the reductions in allow- ables for any year, the difference is car- ried forward to the following year, and the same procedure for reducing allow- ables is repeated. (Note that carryfor- ward of charges to the § 507(a) (2) al- lowable is subject to a special rule. See paragraph (iii) below.) Example 44. DI elects § 503 in 1969 and re- pays a $1,500,000 borrowing, of which $900,- 000 had been expended in Schedule C and $600,000 in Schedule A. In 1969, DI's § 503 allowable is reduced to zero. The remaining $500,000 repayment charge is carried to 1970. In 1970, DI elects § 504(a) with allowables of $500,000 in Schedule A, $400,000 in Sched- ule B and $100,000 in Schedule C. Since the underlying borrowing had been expended in more than one scheduled area, the repayment charge must be allocated be- tween Schedules A and C. Accordingly, under §§1003 and 312(a)(7) a repayment charge of $200,000 is incurred in Schedule A (2/5 X $500,000) and a repayment charge of $300,- 000 is incurred in Schedule C (3/5 X $500,000) . The Schedule A allowable is therefore re- duced by $200,000 from $500,000 to $300,000; the Schedule C allowable is reduced to zero; and the excess of $200,000 reduces the Sched- ule B allowable to $200,000. (iii) Reduction of allowables under § 507. The § 507(a) (2) $4 million Sched- ule A supplemental allowable is reduced only if the repayment is related to direct investment in Schedule A. Also, if there is a carryforward of the repayment charge attributable to Schedule A, the DI may elect in the year (or years) of the carry forward not to have its § 507 (a) (2) allowable reduced. Section 1003(c) (5) (i) and (ii) provide that the § 507 (a) (2) allowable may be re- duced only to the extent that the repay- ment is of a long-term foreign borrow- ing the proceeds of which were expended in or allocated to Schedule A at the time of repayment, or to the extent that the payment was pursuant to a guarantee of a Schedule A AFN borrowing or was to enable a Schedule A AFN to repay its borrowing. Unless the § 1002 transfer of capital falls within one of these cate- gories, the Schedule A supplemental al- lowable will not be reduced, and the re- payment charge will be absorbed entirely by the § 507(a)(1) $1 million allowable in Schedules B/C. A repayment charge attributable to Schedule A will reduce the $4 million Schedule A supplemental allowable of § 507(a) (2) before reducing the $1 mil- lion allowable of § 507(a) (1). Example 45. DI elected § 504(a) during 1969 with allowables of $1 million in Sched- ule A and $1 million in Schedule B. In 1969 DI made $7 million of positive direct invest- ment in Schedule A and $5 million in Sched- ule B, calculated as provided by § 306(a). To comply with the regulations, DI made a long-term foreign borrowing of $10 million and allocated $6 million of proceeds to Schedule A and the remaining $4 million to Schedule B under § 306(e). In 1970 DI elects § 507 and repays $5 million of the borrowing. DI thus incurs a repayment charge of $3 million in Schedule A and $2 million in Schedide B, apportioned as provided by § 312(a) (7). Under §1003, DI's allowable under § 507(a) (2) in Schedule A is reduced to $1 million by the $3 million attributable to Schedule A. The $2 million attributable to Schedule B reduces the § 507(a)(1) allowable to zero in 1970 and again in 1971. Example 46. For 1970 DI elects § 507 and also has an incremental earnings allowable of $200,000 under § 506. DI has a repayment charge of $5,100,000 in Schedule A. Under § 1003, the $4 million allowable in Schedule A is reduced to zero; then the $1 million allowable in Schedules B and C is reduced to zero. The § 506 allowable is then reduced to $100,000. Example 47. DI elects § 507 for 1970 and transfers $5 million to its Schedule C AFN to enable it to repay a borrowing. Under § 1003, the repayment charge will rediice DI's $1 million allowable under § 507(a) (1) to zero in 1970, but the § 507(a) (2) $4 mil- lion Schedule A allowable will not be re- duced. The remaining $4 million of the re- payment charge will be carried forward to future years. If DI continues to elect § 507, the $1 million § 507(a)(1) allowable for Schedules B/C will be reduced to zero in each of the 4 succeeding years. Example 48. DI in 1970 has § 504 (a) and (c) allowables of $2 million in Schedule A, $3 million in Schedule B and $2 million in Schedule C, and a § 506 incremental earn- ings allowable of $1 million. During the year, DI repays a long-term foreign borrowing of $7 milion, the proceeds of which had been expended in Schedule C. If DI elects the § 504 allowables, all of DI's § 504 allowables will be reduced to zero, pursuant to § 1003 (c)(1) and (2), and the only remaining al- lowable will be the $1 million § 506 in- cremental earnings allowable. If DI elects the § 507 allowables, its § 507(a) (1) $1 mil- lion allowable for Schedules B/C will be reduced to zero, as will the § 506 $1 million incremental earnings allowable. The $5 mil- lion remaining of the repayment charge will be carried forward to future years, and the § 507(a)(2) $4 million allowable will not be reduced. If a DI allocated proceeds of long-term foreign borrowing to positive direct in- vestment under § 503 and elects § 507 (or § 504) in any year in which it incurs a repayment charge, the DI shall appor- tion the allocated amount to the ap- propriate schedules in the manner pro- vided by § 306(e) (3). (See § B306-7.) REPRINTED FROM FEDERAL REGISTER, VOL. 35. NO. 195— WEDNESDAY, OCTOBER 7, 1970 64 RULES AND REGULATIONS Example 49. DI elected § 503 lor 1969 and reported on its annual report Form FDI-102F for the year as follows ($000 omitted) : Line 11 (Reinvested earnings) 2,000 Line 12 (Transfers of capital).. 3,000 Line 13 (Use of proceeds) 4,000 Line 15 (Program direct invest- ment) 1,000 In section VIII (Use of proceeds) of Form FDI-102F, DI reported as follows: Line 40 (Expenditure of pro- ceeds) 1,000 Line 41 (Allocation of proceeds under § 306(e)) 3,000 The proceeds expended as reported on Line 40 were from the same borrowing as that al- located under § 306(e). The expenditures were: Schedule A— $850,000, and Schedule C — $150,000. In 1970, DI elects § 507 and repays $2 million of the borrowing. DI must first ap- portion the 1969 § 306(e) deduction (line 41) to each scheduled area, in accordance with § 306(e) (3). Assume that DI recalcu- lates positive direct investment under § 306 (a) (which must include the effect of deduc- tions under § 313(d)(1) for expended pro- ceeds) and apportions the § 306(e) deduc- tions as follows ($000 omitted) : Scheduled area B (al Direct investment under 5306(a) 1,000 2,000 1,000 (b) Proportionate share 25% 50% 25% (c) Share of § 306(e) deduction-. 750 1,500 750 Therefore, DI's total deductions under §§ 306(e) and 313(d) (1) in 1969 for purposes of §312(a)(7) are: Schedule A — $1,600,000; Schedule B — $1,500,000; and Schedule C — $900,000. Consequently, DI's repayment of $2 mil- lion in 1970 will be charged as follows: Schedule A (40%) — $800,000; Schedules B and C (60%)— $1,200,000. Under § 1003, DI's § 507(a) (2) Schedule A allowable will be re- duced by $800,000, and the § 507(a)(1) al- lowable will be reduced to zero with a carry- forward to 1971 of a $200,000 charge against the § 507(a) (1) allowable. There is a special rule regarding treat- ment of a carryforward repayment charge for DIs electing § 507. As discuss- ed above, § 1003(c)(5) provides that in the year in which a repayment charge is incurred, the § 507(a) (2) Schedule A al- lowable will be reduced only to the extent that repayment is of a borrowing attribu- table to positive direct investment in Schedule A. Under § 1003(d), dealing with repayment charges carried forward to future years, the same rule applies, so that the § 507(a)(2) Schedule A al- lowable may be reduced by a carryfor- ward repayment charge only if the re- payment charge results from a borrow- ing attributable to positive direct invest- ment in Schedule A. However, § 1003(d) also states that where the carryforward repayment charge is attributable to positive direct investment in Schedule A, a DI may elect not to have its § 507 (a) (2) allowable reduced. The DI should indicate such election on the Annual Re- port Form FDI-102F filed for the year in question. (However, this election is not available for a repayment charge carried forward from 1968.) Thus, in the year in which a DI incurs a repayment charge attributable to positive direct investment in Schedule A, DI's § 507(a) (2) allowable must be reduced. But, if the repayment charge is carried forward to future years, DI may elect in those years (unless the repayment charge was incurred in 1968) not to have its § 507 (a) (2) reduced. This election may be made in any year in which there is a carryforward repayment charge at- tributable to positive direct investment in Schedule A, even if § 507 was not elected in the year in which the repay- ment charge was incurred. Example 50. DI elects § 507 for 1970 and transfers $10 million to its Schedule A AFN to enable it to repay a borrowing, as au- thorized by § 1002(a) . The repayment charge of $10 million will reduce DI's allowable In Schedule A under § 507(a) (2) to zero. See § 1003(c) (5) (i). The remaining $6 million of the repayment charge will then reduce the § 507(a)(1) allowable in Schedules B/C to zero, and there will be a carryforward charge of $5 million to 1971. In 1971, DI may elect under § 1003(d) not to have its § 507(a) (2) allowable reduced. DI's § 507(a) (1) allowable will be reduced to zero, and DI will also have a $4 million carryforward of the repayment charge to 1972, at which time DI may again elect under § 1003(d) not to have its Sched- ule A supplemental allowable reduced. The S 1003(d) election is not available in the year the repayment charge is first incurred. B1100— Subpart K (§§ 1101-1107) §B1100-1 Introduction. While retaining the Schedule B clas- sification for Canada, Subpart K per- mits unlimited positive direct investment in Canada and excludes direct invest- ment in Canada from the base period and post-January 1, 1968 direct invest- ment calculations for Schedule B. Bor- rowings by a DI from a Canadian person, however, do not qualify as long-term foreign borrowings under § 324. §B1101-1 Canadian AFNs and non- Canadian Schedule B AFNs. Paragraph (a) of § 1101 defines a "Canadian affiliate" as an AFN in Can- ada, and paragraph (b) defines a "non- Canadian Schedule B affiliate" as an AFN in a Schedule B country other than Canada. The term "Canadian affiliate" should not be confused with the defini- tion of "affiliate" in § 903(a). Thus, a "Canadian affiliate" will include a cor- poration organized under the laws of Canada (or any province thereof) in which the DI has a 10 percent or greater voting interest, and a partnership orga- nized under the laws of Canada and a business venture conducted in Canada in which the direct investor has a 10 per- cent or greater profit interest (see §§ 304, 305, 901, and 902). Such "Canadian affiliates" are referred to in this Bulletin as "Canadian AFNs." Example 1. DI has a wholly owned subsid- iary (S) organized under the laws of Canada and a wholly owned subsidiary (T) organized under the laws of the United Kingdom. DI also owns 100 percent of an apartment house complex (U) in Canada and is a 50 percent participant in a partnership (V) organized under Canadian law engaged in the real estate business. T has an 80 percent interest in a subsidiary (X) organized under the laws of Canada, and T also has a branch sales office (W) in Montreal. S has a 60 percent interest in a subsidiary (Z) organized under the laws of Australia. S and X are incor- porated Canadian AFNs of DI. T and Z are incorporated non-Canadian Schedule B AFNs of DI. U, V, and W are unincorporated Canadian AFNs of DI. § B1102— 1 Authorized positive direct in- vestment in Canadian AFNs. Section 1102 authorizes a DI to make positive direct investment in Canadian AFNs in an unlimited amount during any year. Example 2. In 1969, DI acquires all the stock of a Canadian corporation (C) from its sole stockholder, an individual citizen and resident of Germany, for $1 million in cash. The transfer of capital is made to Canada and is generally authorized under § 1102. Example 3. In 1969, DI acquires all the stock of a German corporation (C) from an individual citizen and resident of Canada for $1 million in cash. The transfer of capital is made to Germany (Schedule C) and thus does not fall within the scope of § 1102. Example 4. During 1969 DI purchases, for $2 million, the stock of a Canadian corpora- tion (C) that owns a subsidiary (A) located in Panama. This transaction results in a transfer of capital both to Canada (author- ized under § 1102) and to Schedule A. The purchase price must be apportioned between C and A in a manner that will fairly reflect the relative values of the interests acquired in the two corporations (such as relative book value, relative price/earnings ratios, etc.) . Example 5. In 1969, DI acquires, for $1 million in cash, all the stock of a German corporation (C) from a Canadian corpora- tion in which DI has a 10 percent voting interest. The transfer of capital is made to Canada and is generally authorized under § 1102. Example 6. In 1969, DI acquires, for $1 mil- lion in cash, all the stock of a German cor- poration (C) from a Lebanese corporation (A) in which DI has a 10 percent voting in- terest. C has a wholly owned Canadian subsidiary. DI has made a $1 million transfer of capital to Schedule A, and no apportion- ment is made since the acquisition is from another AFN. The authorization for unlimited posi- tive direct investment in Canada does not constitute an exemption from the re- porting requirements of § 602. Accord- ingly, even DIs with only Canadian AFNs are nevertheless required to file Forms FDI-101, FDI-102, and FDI- 102F (or FDI-102F/S), absent an exemption from reporting. (i) Calculation of positive direct in- vestment in Canada (§§ 1103-1104). Al- though Canada is technically a Schedule B country, the direct investment in Canadian AFNs is excluded from the calculation of direct investment in Schedule B during the base period years and during 1968 and succeeding years. Accordingly, § 1103 (a) and (b) provide that in computing a DI's net transfer of capital to all AFNs in Schedule B dur- ing any year under § 313(c), the only factors considered are transfers of capi- tal between the DI and incorporated non-Canadian Schedule B AFNs and the DI's share of the aggregate net change in net assets of unincorporated non- Canadian Schedule B AFNs. Similarly, § 1104 provides that, in determining a REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY. OCTOBER 7, 1970 RULES AND REGULATIONS 65 DI's share in reinvested earnings of in- corporated AFNs in Schedule B during any year, only the DI's share in rein- vested earnings of incorporated non- Canadian Schedule B APNs is taken into account. In calculating positive direct invest- ment, Canada is treated, in effect, as being in its own separate scheduled area. For example, a transfer of capital by an incorporated Canadian AFN to an incor- porated United Kingdom AFN is treated under § 505(a) (3) as a transfer of capi- tal to the DI from Canada in calculating positive direct investment in Canadian AFNs and as a transfer of capital from the DI to Schedule B in calculating posi- tive direct investment in non-Canadian Schedule B AFNs; if the transferee AFN is in Schedule A or Schedule C, the transfer of capital from the DI would be charged to Schedule A or C, respectively. Similarly, in calculating a DI's share of an incorporated Canadian AFN's rein- vested earnings, Canada is also treated as a separate scheduled area. Conse- quently, the gross amount of a dividend paid by a Canadian AFN to a non-Cana- dian AFN effectively reduces the DI's share in reinvested earnings of all incor- porated AFN's in Canada, while the net amount of the dividend (i.e., net of foreign withholding taxes) effectively increases the DI's share in reinvested earnings of all incorporated AFNs in the payee's scheduled area. The provisions of § § 1103 and 1104 are thus designed to permit computation of direct investment separately for Canada, Schedule A, Schedule B (excluding Canada) and Schedule C. Such pro- visions are also designed, in conjunction with § 505, to prevent Canadian AFNs from being used as a "pass-through" for direct investment in foreign countries other than Canada. Example 7. DI owns an incorporated AFN (X) in Canada and another incorporated AFN (B) in the United Kingdom. In 1969, B makes a 3-year loan to X in the amount of $500,000. Under § 505(a) (3), B is treated as having made a $500,000 transfer of capital to DI, thereby reducing DI's net transfer of capital to incorporated AFNs in Schedule B in 1969 by $500,000, and DI is treated as hav- ing made a transfer of capital in the same amount to X, thereby increasing DI's net transfer of capital to incorporated Canadian AFNs in 1969 by $500,000. All resulting posi- tive direct investment in Canada is author- ized by § 1102. If the loan had been from X to B, the DI would be deemed to have made a $500,000 transfer of capital to B. Example 8. DI has branch sales operations in Canada (X) and Australia (B) , and no other AFNs in Schedule B. In 1969 X's net assets increase by $150,000 and B's branch assets increase by $400,000. DI's net transfer of capital to B in 1969 is $400,000. DI's net transfer of capital to X during 1969 is $150,000. Example 9. DI has a wholly owned subsid- iary in Canada (X) and a wholly owned subsidiary in Japan (B). In 1969 X has earnings of $50,000 and B has earnings of $100,000. X pays a dividend of $25,000 to DI. B pays no dividend. DI's share in reinvested earnings of incorporated non-Canadian Schedule B AFN is $100,000, the earnings and dividend paid by X not being taken into account. DI's share in reinvested earnings of the incorporated Canadian AFN is $25,000. Example 10. DI has a wholly owned sub- sidiary in Canada (X) that, in turn, has a wholly owned subsidiary in the United King- dom (B). During 1969 X earns $500,000 and pays a dividend of $400,000 to DI; B earns $500,000 and pays a dividend of $300,000 to X. DI's share in reinvested earnings of B is $200,000 and in reinvested earnings of X is $400,000 (the $400,000 dividend paid by X is reduced by the $300,000 dividend received from B) . The exemption provided in § 505(b) for short-term trade credits extended by one AFN to another does not apply if either of the AFNs involved in the transaction is a Canadian AFN (see § 1103(c)). Therefore, if a wholly owned Canadian AFN extends a 6-month trade credit of $100,000 to a French AFN on Septem- ber 1, 1969, the transaction results in a $100,000 transfer of capital from the Canadian AFN to the DI, and a $100,000 transfer of capital from the DI to the French AFN. Similarly, if the French AFN extends a 6-month trade credit of $100,000 to the Canadian AFN, the trans- action results in a $100,000 transfer of capital from the French AFN to the DI, and a $100,000 transfer of capital from the DI to the Canadian AFN. § B 1105—1 Canadian foreign balances. Section 1105 provides generally that, for purposes of § 203(c), "Canadian for- eign balances" shall not be included in computing a DI's average end-of-month liquid foreign balances. Accordingly, the regulations do not restrict the amount of liquid foreign balances held by a DI in Canada, and the amount of Canadian foreign balances are excluded for pur- poses of calculating the $25,000 exemp- tion under § 203(c) (2). "Canadian foreign balances" are defined in § 1105(a) to include: (a) Money on deposit in a Canadian bank (as denned in § 1101(c) ), including fixed interest deposits, without regard to the currency deposited and without regard to the terms of such deposits; and (b) negotiable instruments, nonnegotiable instruments and commercial paper of Canadian persons. The term "Canadian bank," as defined in § 1101(c) , includes Canadian branches and offices within Canada of banks organized outside Canada and banks or- ganized under the laws of Canada or of any province of Canada; the term does not include offices of Canadian banks located outside Canada. § Bl 106—1 Long-term foreign borrow- ing from Canada. Section 1106 provides, in general, that a DI's borrowing from a Canadian per- son, whether before or after January 1, 1968, cannot be a "long-term foreign bor- rowing," as denned in § 324. A "Canadian person" is defined in § 1101(d) as an individual resident of Canada, a Canadian bank, or a corporation or other entity (other than a bank) organized under the laws of Canada or any political sub- division thereof. The term "Canadian person" includes foreign branches of Canadian corporations (other than Canadian banks) , and also includes pen- sion, profit-sharing and other similar trusts organized under or governed by the laws of Canada or any political sub- division thereof. For example, the pen- sion fund of a Canadian corporation and the London branch of a Canadian insur- ance company are each considered a "Canadian person." (i) Public offerings prior to April 1, 1968. A borrowing prior to April 1, 1968, involving the public offering of a DI's in- struments of indebtedness is considered long-term foreign borrowing for pur- poses of § 324 if less than 25 percent of the aggregate principal amount of such instruments was sold to "Canadian per- sons" during the original offering. In the event 25 percent or more of the aggregate principal amount of such debt instru- ments was sold to Canadian persons dur- ing the original offering, the portion proved by the DI (to the satisfaction of OFDI) to have been sold to non-Canadi- an and non-U.S. persons will be consid- ered a long-term foreign borrowing for purposes of § 324. Example 11. On March 1, 1968, DI orga- nized an international finance subsidiary (IPS) (see §323) in the United States for the principal purpose of borrowing funds from nonaffiliated foreign nationals and in- vesting such funds in debt or equity securi- ties of AFNs. On March 15, 1968, IFS made a public offering outside the United States of $50 million in 20-year convertible deben- tures, $10 million of which were purchased by Canadian persons for investment. The en- tire $50 million constitutes proceeds of long- term foreign borrowing. Example 12. If $15 million of the foregoing debentures had been purchased by a Canadi- an insurance company for investment during the original offering, only the remaining $35 million would constitute proceeds of a long-term foreign borrowing. Example 13. If, in Example 12, in addition to the $15 million purchased by the Canadian insurance company, $5 million of the deben- tures had been acquired by a Canadian nom- inee of a person within the United States during the original offering, only $30 million of the proceeds would constitute proceeds of a long-term foreign borrowing. (ii) Public offerings on or after April 1, 1968. A borrowing on or after April 1, 1968, involving the public offering of a DI's instruments of indebtedness is con- sidered a long-term foreign borrowing in its entirety if such instruments are sold through underwriters in accordance with agreements limiting such sales to persons other than Canadian or U.S. per- sons, and if the borrowing otherwise qualifies under § 324. It should be noted that sales to Canadian underwriters or securities dealers for resale to non- Canadian and non-U.S. persons will not disqualify the borrowing from being treated in its entirety as a long-term for- eign borrowing. Similarly, sales to Cana- dian agents or fiduciaries acting on be- half of non-Canadian and non-U.S. per- sons will not affect the status of the borrowing under § 324. Following is an example of a provision in the agreement between the DI and Canadian underwriters that would be considered acceptable by OFDI for pur- poses of preserving the long-term for- eign borrowing status of an offering: REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 66 RULES AND REGULATIONS Each Underwriter [agrees] [has agreed] that it will not directly or indirectly sell any Debentures to Canadian persons except for (i) sales to Underwriters or securities dealers who are Canadian persons but who agree that they are purchasing Debentures as principals for resale to persons who are not Canadian or United States persons, and (ii) sales to agents or fiduciaries who are Cana- dian persons but who are acting for the bene- fit of persons who are not Canadian or United States persons. For the purpose of this paragraph, a Canadian person includes an Individual who is a resident of Canada, a corporation, pension, profit-sharing or other trust or other entity (other than a bank) organized under or governed by the laws of Canada or any political subdivision thereof (including the foreign branch of any Canadian corporation other than the for- eign branch of a Canadian bank), and any branch or office within Canada of any of the following: Any bank or trust company or- ganized under the banking laws of Canada or any province thereof, or any private bank or banker subject to supervision and exami- nation under the banking laws of Canada or any province thereof. B1300 — Subpart M (§§ 1301-1303) § B1300-1 Introduction. Subpart M applies to direct invest- ment activities of DIs that are U.S. -flag air carriers, including scheduled and supplemental air carriers and air taxi operators. Under § 1301, such DIs may elect to exclude from transfers of capital the transfer to foreign inventory of certain categories of equipment related to the DIs' operations in foreign air transportation. Sections 1302 and 1303 provide a 30 percent foreign air transport earnings allowable for U.S. -flag air carrier DIs electing to be governed by § 504, based upon financial reports required by the Civil Aeronautics Board with respect to U.S. -flag carriers' international and territorial operations. § B 130 1—1 Exclusions from transfers of capital. Under § 1301, a U.S.-flag air carrier may elect to exclude from net transfers of capital (as determined under § 313) any. increases in certain equipment ac- counts of incorporated or unincorporated APNs: Provided, That the equipment is necessary to the carrier's own operations in foreign air transportation, as dis- tinguished from any separate operations in air transportation of an APN or the operations of third persons to whom the DI or an APN may be providing support or selling parts and services. If the elec- tion is made, related charges for depre- ciation or other expenses must also be excluded in determining earnings of the APNs. A DI electing under this section must do so with respect to all applicable APNs in all scheduled areas. Once made, the election is thereafter binding on the DI and may not be changed for subse- quent years without permission from OFDI. § 1302—1 Earnings allowable for foreign air transport operations. Section 1302 authorizes U.S.-flag air carriers to make positive direct invest- ment, in connection with their foreign air transport operations, of up to 30 percent of aggregate annual foreign air transport earnings for the immediately preceding year. The § 1302 allowable is not subject to schedular limitations, but it may be used only for positive direct in- vestment that is primarily related to the DI's own operations in foreign air transportation. Section 1302 applies automatically to foreign air transport operations of any DI that elects to be governed by § 504 for the year involved. If § 1302 is appli- cable, both transfers of capital related to the DI's foreign air transport opera- tions and aggregate annual foreign air transport earnings will be excluded from the computation of DI's allowables under § 504 (a) or (b). A U.S.-flag air carrier's choices are, therefore, as follows: The § 503 or § 507 allowable for all oper- ations; An adjusted § 504(a) historical allowable for all operations plus a § 1302 allowable for foreign air transport operations only; or An adjusted § 504(b) earnings allowable for all operations plus a § 1302 allowable for foreign air transport operations only. (i) Aggregate annual foreign air transport earnings. The § 1302 allowable is based upon "aggregate annual foreign air transport earnings", defined in § 1302 (b) largely in terms of Civil Aeronautics Board income statement accounts. For this purpose, there is excluded from ter- ritorial and international operating prof- its reported to the Civil Aeronautics Board all related air transport interest and amortization charges, substantially all net operating revenues not directly attributable to air transport (such as profits or losses from hotels, income from foreign-flag air transport operations and other corporate investments) and rele- vant foreign taxes. (ii) Relation of § 1302 to § 504. Invest- ments not related to a carrier's foreign air transportation operations are treated separately for all years (including the base period years). Accordingly, a carrier may make positive direct in- vestment, as provided in § 504, in the same manner and subject to the same limitations as other DIs, except that the historical and earnings allowables under § 504 are adjusted by § 1302(d) to exclude consideration of the carrier's foreign air transport operations. While § 1302 allowables may not be used to authorize positive direct invest- ment in activities other than foreign air transport operations, § 504 allowables may, if the direct investor so chooses, be added to the § 1302 allowables for use in such operations (see § 1302(c) (1) ) . (hi) Carryforwards. Unused foreign air transport allowables may be carried forward to subsequent years (see § 1302 (c) (2) ) . However, if the DI elects either § 503 or § 507 in a later year, the § 1302 carryforward will be lost. The following examples illustrate the effect of § 1302: Example 1. During 1968, a U.S.-flag air carrier (DI) has foreign air transport earn- ings of $25 million and unrelated Investment earnings In Schedule A of $5 million. DI has Schedule A historical allowables under § 504 (a) of $3 million as a result of equity Invest- ment In and loans to hotels, and ground transportation operations associated there- with, in the base period years of 1965 and 1966. Under § 1302, DI would have a world- wide air transport earnings allowable of $7,500,000 (30 percent of $25 million). Dur- ing 1969, the carrier may make woridwide positive direct investment related to air transport activities of $7,500,000 and, assum- ing that the historical allowable under § 504 (a) is elected, unrelated positive direct in- vestment in Schedule A of $3 million. Any unused nonair transport allowable may be used by DI worldwide for air transport ac- tivities, as well as on a schedular basis for operations not related to foreign air trans- port. Any unused air transport allowable may only be used in succeeding years for foreign air transportation operations. Any unused carryforward of allowables under § 504(f) may be used worldwide if devoted to foreign air transportation, or in the appropriate scheduled areas if used for other operations. Example 2. A U.S.-flag air carrier has allow- ables under § 504, unrelated to air transport activities, of zero. For 1969, the carrier elects § 503 and during 1969 transfers $1 million to Schedule C as a contribution to the capital of a wholly owned hotel corporation in that scheduled area. No other relevant transac- tions occur. Such investment is authorized by § 503. No further positive direct invest- ment is authorized during 1969 either in air transport or nonair transport activities. (iv) Repayment charges under § 1003. Section 1302 allowables are, like the al- lowables of Subpart E, reduced by repay- ment charges incurred under § 1003 (see § 1003(c)(1) and, in particular, §1003 (c)(4)). § B1302-2 Beporting. Each DI that is a U.S.-flag air carrier engaged in foreign air transport opera- tions and elects § 504 is required to file separate Forms FDI-102/102F for air- transport investment and earnings and for other investment and earnings (see § 1302(e)). If a U.S.-flag air carrier DI commences foreign air transport activity after June 30, 1969, a revised Form FDI-101 should be filed within 30 days after such status is established indicating air trans- port and nonair transport direct invest- ment experience. § 1303-1 Coordination of §§ 504, 506 and 1302. Section 1302(d) provides that foreign air transport earnings are to be excluded from "annual earnings" computed under § 504(b) (4). However, since "aggregate annual earnings" under § 506 are de- rived from the § 504(b) (4) computation, § 1303(a) provides that foreign air trans- port earnings excluded from § 504(b) (4) should be taken into account for pur- poses of computing aggregate annual earnings under § 506. Section 1303(b) provides that all ref- erence to § 504 in § 506 (a)(4) and (c) shall be deemed to include reference to § 1302(a). The following example illustrates the operation of §§ 1302 and 1303: Example 3. During each of the years 1969 and 1970, DI, a U.S.-flag air carrier, has $1 million in earnings from hotel operations In Schedule B and $3 million of foreign air REPRINTED FROM FEDERAL REGISTER, VOL. 35, NO. 195— WEDNESDAY, OCTOBER 7, 1970 RULES AND REGULATIONS 67 transport earnings. DI has no § 504(a) his- torical allowable, and hotel and foreign air transport earnings during 1966-67 were zero. In 1970 DI elects § 504(b). DI's § 504(b) annual earnings for 1969 were $1 million (since foreign air transport earnings were ex- cluded under § 1302(d) ) . DI's § 504(b) allow- able for 1970 is $300,000 ($1,000,000x30%). DI's § 1302 foreign air transport allow- able is $900,000 ($3,000,000X30%). In 1970 DI also has a § 506 allowable of $400,000, com- puted as follows (000 omitted) : § 506(a) (4) aggregate annual earn- ings for 1970 $4,000 Under § 1303(a) , § 504(b) (4) earn- ings of $1,000 are added to § 1302 (b) foreign air transport earnings of $3,000. Less base period aggregate annual earnings Incremental earnings $4,000 40 percent of incremental earnings.. $1,600 Less the largest of the allowables available under §503 ($1,000); § 504(a) and §1302 ($900); and § 504(b) and §1302 ($1,200), as required by § 1303(b) $1,200 §506 allowable $400 During 1970 DI makes positive direct in- vestment of $400,000 in connection with hotel operations, and positive direct invest- ment of $1,100,000 in connection with for- eign air transport operations. Such positive direct investment is authorized by §§ 504(b) . 1302, and 506. DI then has a carryforward under § 506 of $100,000 because, under § 506(c), positive direct investment to the extent authorized by § 504 (and § 1302, as provided by § 1302(b) ) is deemed made pur- suant to those sections and not under § 506. Only the excess of $300,000 is charged against DI's § 506 allowable. B1400 — Subpart N (§§ 1401-1405) § B 1400-1 Introduction. Subpart N of the regulations, which deals with "overseas finance subsidi- aries" (OFSs) , was published in the Fed- eral Register in final form on May 7, 1970 (35 F.R. 7228), effective as of January 1, 1970. In general, Subpart N accords special status to funds acquired in certain bor- rowings from sources outside the United States and Canada by an AFN which has been qualified as an OFS. When such funds are lent by the OFS to the DI, they become available proceeds of long-term foreign borrowing and may offset posi- tive direct investment. Such funds may also be transferred between the OFS and other AFNs of the DI without involving a net transfer of capital. Repayment by the DI or the OFS of an OFS's qualified foreign borrowing has much the same effect as repayment of long-term foreign borrowing by a DI. All other subparts of the regulations apply to all OFS trans- actions except to the extent specifically modified by Subpart N. The Office has previously issued spe- cific authorizations, under § 801, which, in effect, treat certain borrowing made through an OFS as if the borrowing were a long-term foreign borrowing by the DI. Adoption of Subpart N lias made it un- necessary for a DI to obtain such a spe- cific authorization. Any such specific au- thorizations issued in 1968, 1969, or 1970 are superseded by Subpart N beginning January 1, 1970, and, consequently, transactions involving OFSs occurring during 1970 and thereafter are governed by Subpart N. § B1401-1 Definitions. The definition of an OFS is contained in § 1401(a) . Section 1401(a) (1) and (2) require that an OFS be a wholly owned, non-Canadian AFN of the DI. Section 1401(a) (3) provides that an AFN may qualify as an OFS only if the AFN's principal business is to borrow funds from foreign nationals, other than AFNs or Canadian persons, on terms which would qualify such borrowing as long-term foreign borrowing if made by a DI (see §140Kb)) and to lend such borrowed funds to the DI or to use such funds in loans to or acquisition of equity interests in other AFNs. The principal business requirement is satisfied if the OFS is at all times a financing com- pany (i.e., does not engage in manufac- turing, sale of goods or services, or other similar operations) ; does not deal or trade in securities; and substantially all of its borrowed funds are held, at all times, in the form of debt obligations of the DI, debt obligations of AFNs or equity interests in AFNs. However, pending commitment of borrowed funds, or in the interval between changes in the com- mitment of such funds, an OFS may temporarily hold such funds in the form of government securities; or in the form of debt obligations (including, without limitation, negotiable and nonnegotiable instruments, commercial paper, demand and time deposits and certificates of deposit) having a maturity of less than 12 months. Section 1401(a) (4) provides that a DI may claim the benefits of the special rules contained in Subpart N only if its OFS is formally qualified in accordance with the procedures set forth in § 1402. Note that contributions of funds or other property by the DI or AFNs to the equity capital of the OFS constitute transfers of capital to the OFS, and such transfers are not affected by Subpart N. Section 1401(b) defines "overseas bor- rowing" as borrowing by an OFS which would be long-term foreign borrowing, under § 324, if made by a DI. Section 1401(c) defines "overseas pro- ceeds" as the funds or other property received by the OFS in overseas borrow- ing. Overseas proceeds invested by the OFS or the DI in debt obligations of or equity interests in other AFNs of the DI remain overseas proceeds until repay- ment of the overseas borrowing or pro- ceeds borrowing. See § 1404. Section 1401(d) defines "available overseas proceeds" as overseas proceeds held by the OFS. Notwithstanding § 505, overseas proceeds may be transferred by the OFS to AFNs of the DI without being included in the computation of net trans- fer of capital under § 313. See § 1403 (a) (2). In addition, overseas proceeds trans- ferred to the DI in proceeds borrowing, as defined in § 1401(e), are thereafter treated as available proceeds of long- term foreign borrowing. See § 1403(a) ( 1 ) . The proceeds borrowing must be continuously outstanding for at least 12 months after the original date of the loan, and any debt instrument evidenc- ing such loan may not be sold or other- wise transferred by the OFS prior to repayment or cancellation. If the OFS ceases to hold any such debt instrument, the loan of overseas proceeds to the DI will fail to qualify as proceeds borrow- ing, and the Office may revoke the OFS's qualification, as provided in §1402