Part I. Rulings — Internal Revenue Bulletin 1998-10

The provisions of § 165(i) apply only to losses that are otherwise deductible under § 165(a). An individual taxpayer may deduct losses if they are incurred in a trade or business, if they are incurred in a transaction entered into for profit, or if they are casualty losses under § 165(c)(3).

The President has determined that during 1997 the areas listed below have been adversely affected by disasters of sufficient severity and magnitude to warrant assistance by the Federal Government under the Act.

DRAFTING INFORMATION

The principal author of this revenue ruling is Jonathan Strum of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Strum on (202) 622-4960 (not a toll-free call).

Section 42.—Low-Income Housing Credit

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 165.—Losses

26 CFR 1.165–11: Election in respect of losses attributable to a disaster.

Election in respect of losses attribut- able to a disaster. This ruling lists the areas declared by the President to qualify as major disaster areas under the Disaster Relief and Emergency Assistance Act since the publication of Rev. Rul. 97–11.

Rev. Rul. 98–12

Under § 165(i) of the Internal Revenue Code, if a taxpayer suffers a loss attributable to a disaster occurring in an area subsequently determined by the President of

Disaster Areas in 1997

Alabama

Counties of Baldwin, Choctaw, and Mobile

Arkansas

Counties of Baxter, Clark, Clay, Conway, Craighead, Cross, Greene, Hempstead, Hot Spring, Independence, Jackson, Jefferson, Lawrence, Lee, Lincoln, Lonoke, Mississipi, Nevada, Newton, Poinsett, Pope, Pulaski, Saline, White, and Woodruff

Counties of Bradley, Clay, Cleburne, Cleveland, Columbia, Craighead, Dallas, Drew, Faulkner, Grant, Greene, Izard, Jackson, Jefferson, Lafayette, Lincoln, Lonoke, Monroe, Montgomery, Ouachita, Poinsett, Searcy, Sharp, St. Francis, Stone, Union, Van Buren, and White

California

Counties of Alameda, Alpine, Amador, Butte, Calaveras, Colusa, Contra Costa, Del Norte, El Dorado, Fresno, Glenn, Humboldt, Kings, Lake, Lassen, Madera, Marin, Mariposa, Mendocino,

the United States to warrant assistance by the Federal Government under the Disaster Relief and Emergency Assistance Act, 42 U.S.C. §§ 5121–5204c (1988 & Supp. V 1993) (Act), the taxpayer may elect to claim a deduction for that loss on the taxpayer’s federal income tax return for the taxable year immediately preceding the taxable year in which the disaster occurred.

Section 1.165–11(e) of the Income Tax Regulations provides that the election to deduct a disaster loss for the preceding year must be made by filing a return, an amended return, or a claim for refund on or before the later of (1) the due date of the taxpayer’s income tax return (determined without regard to any extension of time to file the return) for the taxable year in which the disaster actually occurred, or (2) the due date of the taxpayer’s income tax return (determined with regard to any extension of time to file the return) for the taxable year immediately preceding the taxable year in which the disaster actually occurred.

Type of Disaster Date of Disaster

Severe storms, flooding, and high winds associated with Hurricane Danny

Severe storms and tornadoes

Severe storms and flooding

Severe storms, flooding, and mud and land slides

July 17-22, 1997

March 1-4, 1997

April 4-21, 1997

December 28, 1996-April 1, 1997

1998–10 I.R.B. 5 March 9, 1998

Merced, Modoc, Mono, Monterey, Napa, Nevada, Placer, Plumas, Sacramento, San Benito, San Francisco, San Joaquin, San Luis Obispo, San Mateo, Santa Clara, Santa Cruz, Shasta, Sierra, Siskiyou, Solano, Sonoma, Stanislaus, Sutter, Tehama, Trinity, Tulare, Tuolumne, Yolo, and Yuba; and the City of Morgan Hill

Colorado

Counties of Baca, Clear Creek, Crowley, Elbert, Kiowa, Larimer, Lincoln, Logan, Morgan, Otero, Phillips, Prowers, and Weld

Florida

Counties of Citrus, Hernando, Hillsborough, Lake, Orange, Osceola, Pasco, Polk, and Sumter

Guam

Territory of Guam

Idaho

Counties of Adams, Benewah, Boise, Bonner, Boundary, Camas, Clearwater, Elmore, Gem, Idaho, Koontenai, Latah, Nez Perce, Owyhee, Payette, Shoshone, Valley and Washington

Counties of Benewah, Bingham, Bonner, Bonneville, Boundary, Butte, Custer, Fremont, Jefferson, Kootenai, Madison, and Shoshone

Illinois

Counties of Alexander, Gallatin, Hardin, Massac, Pope, and Pulaski

County of Cook

Indiana

Counties of Clark, Crawford, Dearborn, Floyd, Harrison, Jefferson, Ohio, Perry, Posey, Spencer, Switzerland, Vanderburgh, and Warrick

Iowa

Counties of Cass, Clarke, Iowa, Jasper, Madison, Mahaska, Marion, Mills, Polk, Pottawattamie, Poweshiek, Union, and Warren

Kentucky

Counties of Adair, Anderson, Ballard,

Severe storms, heavy rains, flash floods, other flooding, mud and land slides, and severe ground saturation

Severe storms, high winds, tornadoes, and flooding

Typhoon Paka and associated torrential rains, high winds, high surf, and tidal surges

Severe storms, flooding, and mud and land slides

Severe storms, snowmelt, and mud and land slides

Severe storms and flooding

Severe thunder storms and flash flooding

Severe storms and flooding

Severe winter storm

Severe storms, flooding, and tornadoes

July 28-August 12, 1997

December 25, 1997-January 14, 1998

December 16-17, 1997

November 16, 1996-January 4, 1997

March 14-June 30, 1997

March 1-April 1, 1997

August 16-17, 1997

February 28-March 31, 1997

October 26-28, 1997

March 1-24, 1997

March 9, 1998 6 1998–10 I.R.B.

Barren, Bath, Boone, Bourbon, Boyd, Boyle, Bracken, Breathitt, Breckinridge, Bullitt, Butler, Caldwell, Calloway, Campbell, Carlisle, Carroll, Carter, Casey, Christian, Clark, Clay, Crittenden, Daviess, Edmonson, Elliott, Estill, Fayette, Fleming, Floyd, Franklin, Fulton, Gallatin, Grant, Graves, Grayson, Green, Greenup, Hancock, Hardin, Harrison, Hart, Henderson, Henry, Hickman, Hopkins, Jefferson, Jessamine, Johnson, Kenton, Knott, Larue, Lawrence, Lee, Leslie, Letcher, Lewis, Livingston, Logan, Lyon, Magoffin, Marion, Marshall, Mason, McCracken, McLean, Meade, Menifee, Mercer, Metcalfe, Monroe, Montgomery, Morgan, Muhlenberg, Nelson, Nicholas, Ohio, Oldham, Owen, Pendleton, Perry, Pike, Powell, Robertson, Rowan, Russell, Scott, Shelby, Simpson, Spencer, Taylor, Todd, Trigg, Trimble, Union, Warren, Washington, Webster, and Woodford

Louisiana

Counties of Calcasieu, Cameron, and Jefferson Davis

Michigan

Counties of Genesee, Macomb, Oakland, Saginaw, and Wayne

Micronesia

Yap Proper, Ulithi Atoll, and Ngula Atoll of Yap State

Minnesota

Counties of Becker, Beltrami, Benton, Big Stone, Blue Earth, Brown, Chippewa, Clay, Clearwater, Cottonwood, Douglas, Faribault, Grant, Hubbard, Jackson, Kandiyohi, Kittson, Lac Qui Parle, Lake of the Woods, Le Sueur, Lincoln, Lyon, Mahnomen, Marshall, Martin, McLeod, Meeker, Murray, Nicollet, Nobles, Norman, Otter Tail, Pennington, Pipestone, Polk, Pope, Red Lake, Redwood, Renville, Rock, Roseau, Sherburne, Sibley, Stearns, Steele, Stevens, Swift, Todd, Traverse, Wadena, Waseca, Watonwan, Wilkin, Wright, and Yellow Medicine

Counties of Aitkin, Anoka, Becker, Beltrami, Benton, Big Stone, Blue Earth, Brown, Carver, Cass, Chippewa, Clay, Clearwater, Dakota, Douglas,

Severe ice storm

Severe storms, tornadoes, and flooding

Typhoon Fern

Severe winter storms

Severe flooding, severe winter storms, snowmelt, high winds, rains, and ice

January 12-17, 1997

July 2, 1997

December 25-26, 1996

January 3-February 3, 1997

March 21-May 24, 1997

1998–10 I.R.B. 7 March 9, 1998

Goodhue, Grant, Hennepin, Houston, Hubbard, Kandiyohi, Kittson, Lac Qui Parle, Lake of the Woods, Le Sueur, Lincoln, Lyon, Mahnomen, Marshall, McLeod, Morrison, Murray, Nicollet, Norman, Otter Tail, Pennington, Polk, Pope, Ramsey, Red Lake, Redwood, Renville, Roseau, Scott, Sherburne, Sibley, St. Louis, Stearns, Stevens, Swift, Todd, Traverse, Wabasha, Wadena, Washington, Wilkin, Winona, Wright, and Yellow Medicine

Counties of Anoka, Hennepin, Isanti, Kandiyohi, Ramsey, Sherburne, and Wright

Mississippi

Counties of Bolivar, Tunica, Warren, and Washington

Montana

Counties of Broadwater, Carbon, Dawson, Deer Lodge, Flathead, Judith Basin, Lincoln, Madison, Meagher, Missoula, Musselshell, Park, Prairie, Ravalli, Richland, Roosevelt, Sanders, Stillwater, Sweet Grass, Treasure, Valley, Wheatland, Yellowstone and the Flathead Indian Reservation of the Confederated Salish and Kootenai Tribes

Nebraska

Counties of Adams, Banner, Buffalo, Butler, Cass, Cheyenne, Clay, Custer, Dawson, Dodge, Douglas, Fillmore, Franklin, Frontier, Furnas, Gosper, Hall, Hamilton, Harlan, Hayes, Hitchcock, Kearney, Kimball, Lancaster, Lincoln, Nuckolls, Otoe, Phelps, Polk, Red Willow, Saline, Sarpy, Saunders, Scotts Bluff, Seward, Thayer, Washington, Webster, and York

Nevada

Counties of Churchill, Douglas, Lyon, Mineral, Storey, and Washoe; and the City of Carson City; and the Walker River Paiute tribal lands located in Churchill, Lyon, and Mineral Counties

New Jersey

County of Atlantic

Severe storms, flooding, tornadoes, and high winds

Flooding

Severe storms, ice jams, snowmelt, flooding, and extreme soil saturation

Severe snow storms, rains, and strong winds

Severe storms, flooding, and mud and land slides

Severe storms and flooding

June 28-July 27, 1997

February 28-April 21, 1997

March 1-August 6, 1997

October 24-26, 1997

December 20, 1996-January 17, 1997

August 20-21, 1997

March 9, 1998 8 1998–10 I.R.B.

North Dakota

All Counties

Counties of Adams, Barnes, Benson, Billings, Bottineau, Bowman, Burke, Burleigh, Cass, Cavalier, Dickey, Divide, Dunn, Eddy, Emmons, Foster, Golden Valley, Grand Forks, Grant, Griggs, Hettinger, Kidder, Lamoure, Logan, McHenry, McIntosh, McKenzie, McLean, Mercer, Morton, Mountrail, Nelson, Oliver, Pembina, Pierce, Ramsey, Ransom, Renville, Richland, Rolette, Sargent, Sheridan, Sioux, Slope, Stark, Steele, Stutsman, Towner, Traill, Walsh, Ward, Wells and Williams

Northern Marianas

Islands of Rota, Saipan, and Tinian

Island of Rota

Ohio

Counties of Adams, Athens, Brown, Clermont, Gallia, Hamilton, Highland, Hocking, Jackson, Lawrence, Meigs, Monroe, Morgan, Pike, Ross, Scioto, Vinton and Washington

Oregon

Counties of Baker, Coos, Douglas, Gilliam, Grant, Jackson, Josephine, Klamath, Lake, Lane, Morrow, Umatilla, Wallowa, and Wheeler

South Dakota

Counties of Butte, Harding, Hutchinson, Lake, Meade, Minnehaha, Moody, Pennington, Perkins, and Turner

All counties

Counties of Aurora, Beadle, Bennett, Bon Homme, Brookings, Brown, Brule, Buffalo, Butte, Campbell, Charles Mix, Clark, Clay, Codington, Corson, Custer, Davison, Day, Deuel, Dewey, Douglas, Edmunds, Fall River, Faulk, Grant, Gregory, Haakon, Hamlin, Hand, Hanson, Harding, Hughes, Hutchinson, Hyde, Jackson, Jerauld, Jones, Kingsbury, Lake, Lawrence, Lincoln, Lyman, Marshall, McCook, McPherson, Meade, Mellette, Miner, Minnehaha, Moody, Pennington, Perkins, Potter, Roberts, Sanborn,

Major winter storm and blizzard

Severe flooding, severe winter storm, heavy spring rains, rapid snowmelt, high winds, ice jams, and ground saturation

Super Typhoon Keith

Typhoon Paka

Severe storms and flooding

Severe winter storms, flooding, and mud and land slides

Severe winter storm

Severe winter storms and blizzard

Severe flooding, severe winter storms, heavy spring rains, rapid snowmelt, high winds, and ice jams

January 3-31, 1997

February 28-May 24, 1997

November 2-3, 1997

December 16-17, 1997

February 28-March 17, 1997

December 25, 1996-January 6, 1997

November 13-26 1996

January 3-31, 1997

February 3- May 24, 1997

1998–10 I.R.B. 9 March 9, 1998

Shannon, Spink, Stanley, Sully, Todd, Tripp, Turner, Union, Walworth, Yankton, and Ziebach

Tennessee

Counties of Benton, Carroll, Cheatham, Chester, Clay, Davidson, DeKalb, Decatur, Dickson, Dyer, Gibson, Grundy, Hardeman, Hardin, Henderson, Henry, Houston, Humphreys, Jackson, Lake, Lauderdale, Madison, McNairy, Montgomery, Obion, Shelby, Stewart, Sumner, Tipton, and Weakley

Counties of Bradley, Grundy, Hamilton, Polk, Sequatchie, and Smith

Texas

Counties of Bandera, Bexar, Blanco, Burnet, Comal, Eastland, Edwards, Gillespie, Goliad, Guadalupe, Hays, Kendall, Kerr, Kimble, Llano, Mason, Medina, Real, San Saba, Travis, and Uvalde

Vermont

Counties of Caledonia, Franklin, Lamoille, Orleans, and Washington

Washington

Counties of Adams, Asotin, Benton, Chelan, Clallam, Clark, Columbia, Cowlitz, Douglas, Ferry, Franklin, Garfield, Grant, Grays Harbor, Island, Jefferson, King, Kitsap, Kittitas, Klickitat, Lewis, Lincoln, Mason, Okanogan, Pacific, Pend Oreille, Pierce, San Juan, Skagit, Skamania, Snohomish, Spokane, Stevens, Thurston, Walla Walla, Whatcom, Whitman, and Yakima

Counties of Clallam, Grays Harbor, Jefferson, King, Kitsap, Lincoln, Mason, Pacific, Pend Oreille, Snohomish, Spokane, Stevens, and Thurston

County of Pend Oreille

West Virginia

Counties of Braxton, Cabell, Calhoun, Clay, Gilmer, Jackson, Kanawha, Lincoln, Mason, Putnam, Roane, Tyler, Wayne, Wetzel, Wirt, and Wood

Heavy rains, tornadoes, flooding, hail, and high winds

Severe storms and tornadoes

Severe thunderstorms and flooding

Excessive rainfall, high winds, and flooding

Severe winter storms, flooding, and mud and land slides

Heavy rains, snow melt, flooding, and mud and land slides

Flooding and snowmelt

Heavy rains, wind driven rains, high winds, flooding, and slides

February 28- March 24, 1997

March 28-29, 1997

June 21-July 15, 1997

July 15-17, 1997

December 26, 1996-February 10, 1997

March 18-28, 1997

April 10-June 30, 1997

February 28-March 15, 1997

March 9, 1998 10 1998–10 I.R.B.

Wisconsin

Counties of Milwaukee, Ozaukee, Washington, and Waukesha

Section 280F.—Limitation on Depreciation for Luxury Automobiles; Limitation Where Certain Property Used for Personal Purposes

26 CFR 280F–7: Property leased after December 31, 1986.

This procedure provides owners and lessees of passenger automobiles designed to be propelled primarily by electricity and built by an original equipment manufacturer (electric automobiles) with tables detailing the limitations on depreciation deductions for owners of electric automobiles first placed in service after August 5, 1997, and before January 1, 1998, and the amounts to be included in income by lessees of electric automobiles first leased after August 5, 1997, and before January 1, 1998. See Rev. Proc. 98–24, page 31.

Section 280G.—Golden Parachute Payments

Federal short-term, mid-term, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 354.—Exchanges of Stock and Securities in Certain Reorganizations

26 CFR 1.354–1: Exchanges of stock and securities in certain reorganizations.

The revenue ruling provides that an acquisition of stock for voting stock, accompanied under the reorganization plan by an exchange of securities for securities that are of equal fair market value and equal principal amout, qualifies as a corporate reorganization under § 368(a)(1)(B) of the Code. The revenue ruling also provides that the securities-forsecurities exchange is governed by the nonrecognition provisions of § 354(a)(1). Rev. Ruls. 68–637, 69–142, 70–41, 70–269, and 78–408 modified, superseded, amplified, as applicable. See Rev. Rul. 98–10 on this page.

Section 368.—Definitions Relating to Corporate Reorganizations

26 CFR 1.368-2: Definition of terms. (Also § 354; § 1.354–1.)

Reorganizations; exchange of securi- ties. An acquisition of sock for solely vot

Severe storms and flooding June 21-23, 1997

ing stock, accompanied under the reorganization plan by an exchange of securities for securities that are of equal fair market value and equal principal amount, qualifies as a corporate reorganization under section 368(a)(1)(B) of the Code. Section 354(a)(1) nonrecognition applies to the securities-for-securities exchange.

Rev. Rul. 98–10

ISSUE

Where a stock for stock acquisition otherwise qualifying under § 368(a)(1)(B) of the Internal Revenue Code is accompanied by an exchange of securities, how should the transaction be treated?

FACTS

The facts are substantially similar to the facts in Rev. Rul. 69–142, 1969–1 C.B. 107.

Corporation X acquires all of the outstanding capital stock of Corporation Y in exchange for voting stock of X . Corporation Y is a solvent corporation. Prior to the exchange, Y has an issue of six percent fifteen-year debentures outstanding. Pursuant to the plan of reorganization, X acquires all the outstanding debentures of Y in exchange for an equal principal amount of new six percent fifteen-year debentures of X . Some of the debentures of Y are held by its shareholders, but a substantial proportion of the Y debentures are held by persons who own no stock.

X is in control of Y immediately after the acquisition of the Y stock. The X and Y debentures constitute “securities” within the meaning of § 354(a)(1) and, thus, do not represent an equity interest. Disregarding the exchange of debentures, the transaction meets the requirements of

368(a)(1)(B).

LAW AND ANALYSIS

Section 368(a)(1)(B) provides that a reorganization includes the acquisition by one corporation, in exchange solely for all or a part of its voting stock, of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation.

Section 1.368–2(c) of the Income Tax Regulations provides:

In order to qualify as a “reorganization” under section 368(a)(1)(B), the acquisition by the acquiring corporation of stock of another corporation must be in exchange solely for all or a part of the voting stock of the acquiring corporation . . ., and the acquiring corporation must be in control of the other corporation immediately after the transaction. If, for example, Corporation X in one transaction exchanges nonvoting preferred stock or bonds in addition to all or a part of its voting stock in the acquisition of stock of Corporation Y, the transaction is not a reorganization under section 368(a)(1)(B). Section 354(a)(1) provides that no gain or loss will be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in another corporation a party to a reorganization.

In the circumstances set forth above, the Y shareholders receive exclusively voting stock of X as consideration for the exchange of their Y stock. The fact that a substantial proportion of the Y debentures is held by bondholders who own no stock in Y has the effect of ensuring that the value of the debentures issued by X in exchange for the debentures of Y realistically reflects the value of the Y debentures alone and does not constitute indirect nonqualifying consideration for the Y stock. Because the Y shareholders, in their capacity as shareholders, receive only X voting stock, the transaction constitutes a reorganization within the meaning of § 368(a)(1)(B).

Although the acquisition by X of the debentures of Y in exchange for debentures of X occurs as part of the overall transaction, it is not a part of the stockfor-stock exchange which qualifies as a reorganization. It is, however, an exchange of securities in parties to a reorganization which occurs in pursuance of the plan of reorganization, and, therefore, meets all the conditions of § 354(a)(1).

1998–10 I.R.B. 11 March 9, 1998

Accordingly, any gain or loss realized by the debenture holders of Y as a result of their exchange of their Y debentures for an equal principal amount of debentures of X will not be recognized. Section 354(a)(1). If, under different facts, the principal amount of the debentures of X was greater than the principal amount of the debentures of Y, §§ 354(a)(2) and 356(d) would apply to require the debenture holders of Y to recognize some or all of any gain realized.

HOLDING

The exchange of Y stock for X stock is a reorganization described in § 368(a)(1)(B); and any gain or loss realized by the shareholders of Y as a result of the exchange will not be recognized. Section 354(a)(1). The separate exchange of Y debentures for X debentures is an exchange in pursuance of the plan of reorganization described in § 368(a)(1)(B). Thus, any gain or loss realized by the debenture holders of Y as a result of their exchange of their Y debentures for an equal principal amount of debentures of X will not be recognized. Section 354(a)(1).

In certain cases, rights to acquire stock of a party to a reorganization are “securities” for purposes of § 354. See § 1.354– 1(e) (as amended by T.D. 8752, 1998–9 I.R.B. 4, effective for exchanges occurring on or after March 9, 1998). An exchange of such rights, although separate from a § 368 exchange, may also be in pursuance of the plan of reorganization. In such cases, any gain or loss realized by the holder of such rights as a result of the exchange will not be recognized. Section 354(a)(1).

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 69–142, which dealt with substantially identical facts, is modified and superseded.

Rev. Rul. 70–41, 1970–1 C.B. 77, deals with a stock-for-stock exchange accompanied by an exchange of Acquired debentures for Acquiring stock. It is modified such that § 354 applies to the exchange of debentures for stock.

Rev. Rul. 78–408, 1978–2 C.B. 203, deals with a stock-for-stock exchange accompanied by a warrant-for-warrant ex

change. It is modified such that § 354 applies to the exchange of warrants provided that the warrants constitute securities. See § 1.354–1(e).

Rev. Ruls. 68–637, 1968–2 C.B. 158, and 70–269, 1970–1 C.B. 82, similarly deal with reorganization exchanges accompanied by exchanges of warrants or options. Each is amplified such that § 354 applies to the exchange of warrants or options, provided that, as in Rev. Rul. 78–408 above, the warrants or options constitute securities.

PROSPECTIVE APPLICATION

Section 7805(b) provides that the Secretary may prescribe the extent, if any, to which any ruling relating to the internal revenue laws shall be applied without retroactive effect. Pursuant to the authority contained in § 7805(b), this revenue ruling will be applied only to corporate reorganizations in which the exchange of securities occurs on or after March 9, 1998, the date this revenue ruling is published in the Internal Revenue Bulletin. Transactions in which the exchange of securities occurs prior to this date will continue to be governed by the rules as they existed prior to publication of this revenue ruling.

DRAFTING INFORMATION

The principal author of this revenue ruling is Michael J. Danbury of the Office of Assistant Chief Counsel (Corporate). For further information regarding this revenue ruling, contact Mr. Danbury on (202) 622-7750 (not a toll-free call).

Section 382.—Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change

The adjusted federal long-term rate is set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 412.—Minimum Funding Standards

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 467.—Certain Payments for the Use of Property or Services

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 468.—Special Rules for Mining and Solid Waste Reclamation and Closing Costs

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 482.—Allocation of Income and Deductions Among Taxpayers

Federal short-term, mid-term, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 483.—Interest on Certain Deferred Payments

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 642.—Special Rules for Credits and Deductions

Federal short-term, mid-term, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 807.—Rules for Certain Reserves

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 846.—Discounted Unpaid Losses Defined

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 985.—Functional Currency

The Treasury Department and the IRS are soliciting comments on the tax issues raised by the conver

March 9, 1998 12 1998–10 I.R.B.

sion of certain European countries’ currencies to a single European currency (euro). See Announcement 98–18, page 44.

26 CFR 1.985–5: Adjustments Required Upon Change in Functional Currency

The Treasury Department and the IRS are soliciting comments on the tax issues raised by the conversion of certain European countries’ currencies to a single European currency (euro). See Announcement 98–18, page 44.

Section 989.—Other Definitions and Special Rules

Section 1274.—Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property

(Also Sections 42, 280G, 382, 412, 467, 468, 482, 483, 642, 807, 846, 1288, 7520, 7872.)

Federal rates; adjusted federal rates; adjusted federal long-term rate, and the long-term exempt rate. For purposes of sections 1274, 1288, 382, and other sections of the Code, tables set forth the rates for March 1998.

Rev. Rul. 98–11

This revenue ruling provides various prescribed rates for federal income tax purposes for March 1998 (the current month.) Table 1 contains the short-term, mid-term, and long-term applicable fed eral rates (AFR) for the current month for purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the short-term, mid-term, and long-term adjusted applicable federal rates (adjusted AFR) for the current month for purposes of section 1288(b). Table 3 sets forth the adjusted federal long-term rate and the long-term tax-exempt rate described in section 382(f). Table 4 contains the appropriate percentages for determining the low-income housing credit described in section 42(b)(2) for buildings placed in service during the current month. Finally, Table 5 contains the federal rate for determining the present value of an annuity, an interest for life or for a term of years, or a remainder or a reversionary interest for purposes of section 7520.

Applicable Federal Rates (AFR) for March 1998

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-Term

AFR 5.39% 5.32% 5.29% 5.26% 110% AFR 5.94% 5.85% 5.81% 5.78% 120% AFR 6.48% 6.38% 6.33% 6.30% 130% AFR 7.04% 6.92% 6.86% 6.82%

Mid-Term

AFR 5.59% 5.51% 5.47% 5.45% 110% AFR 6.15% 6.06% 6.01% 5.98% 120% AFR 6.72% 6.61% 6.56% 6.52% 130% AFR 7.29% 7.16% 7.10% 7.06% 150% AFR 8.44% 8.27% 8.19% 8.13% 175% AFR 9.87% 9.64% 9.53% 9.45%

Long-Term

AFR 5.91% 5.83% 5.79% 5.76% 110% AFR 6.51% 6.41% 6.36% 6.33% 120% AFR 7.12% 7.00% 6.94% 6.90% 130% AFR 7.72% 7.58% 7.51% 7.46%

1998–10 I.R.B. 13 March 9, 1998

REV. RUL. 98–11 TABLE 2

Adjusted AFR for March 1998

Period for Compounding

Annual Semiannual Quarterly Monthly Short-term adjusted AFR 3.77% 3.74% 3.72% 3.71%

Mid-term adjusted AFR 4.14% 4.10% 4.08% 4.07%

Long-term adjusted AFR 4.88% 4.82% 4.79% 4.77%

REV. RUL. 98–11 TABLE 3

Rates Under Section 382 for March 1998

Adjusted federal long-term rate for the current month 4.88%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted federal long-term rates for the current month and the prior two months.) 5.10%

REV. RUL. 98–11 TABLE 4

Appropriate Percentages Under Section 42(b)(2) for March 1998

Appropriate percentage for the 70% present value low-income housing credit 8.35%

Appropriate percentage for the 30% present value low-income housing credit 3.58%

REV. RUL. 98–11 TABLE 5

Rate Under Section 7520 for March 1998

Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest 6.8%

March 9, 1998 14 1998–10 I.R.B.

(1)(B)(i) merely because it also provides for a payment (or payments) made by reason of the death of one or more individuals. Thus, under the proposed regulations, the exception in section 1275(a)(1)(B)(i) applies only to an immediate annuity contract with level (or decreasing) payments for the life (or lives) of one or more individuals. No deferred annuity contract qualifies for the exception.

Several commentators questioned the approach of the proposed regulations. In particular, they contended that the exception in section 1275(a)(1)(B)(i) should not be limited to those annuity contracts that require periodic payments to begin within one year of the date of the initial investment in the contract. That is, deferred annuities, if dependent in whole or substantial part on an individual’s (or several individuals’) survival, should also qualify for the exception in section 1275(a)(1)(B)(i). Other commentators took issue with this point of view and contended that the proposed regulations should be finalized without substantial change.

After a careful review of this issue, the IRS and the Treasury have modified the regulations to eliminate the requirement that annuity distributions begin within one year of the date of the initial investment in the contract. Instead, as suggested by the legislative history, the final regulations interpret section 1275(a)(1)(B)(i) as excepting from the definition of debt instrument only those annuity contracts that contain terms ensuring that the life contingency under the contract is both “real and significant.” H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 887 (1984), 1984–3 (Vol. 2) C.B. 141. The Treasury and the IRS have determined that the life contingency under an annuity contract is “real and significant” within the meaning of the legislative history only if, on the day the contract is purchased, there is a high probability that total distributions under the contract will increase commensurately with the longevity of the individual (or individuals) over whose life (or lives) the distributions are to be made. (These individuals are hereinafter referred to as annuitants.) The final regulations, therefore, provide a two-pronged general rule: An annuity contract qualifies for the exception in section 1275(a)(1)(B)(i) only if it both: (1) provides for periodic distrib

Section 1275.—Other Definitions and Special Rules

26 CFR 1.1275–1: Definitions.

T.D. 8754

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Debt Instruments With Original Issue Discount; Annuity Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the federal income tax treatment of certain annuity contracts. The regulations determine which of these contracts are taxed as debt instruments for purposes of the original issue discount provisions of the Internal Revenue Code. The regulations provide needed guidance to owners and issuers of these contracts.

DATES: Effective date: The regulations are effective February 9, 1998.

Applicability dates: For dates of applicability, see §1.1275–1(j)(8).

FOR FURTHER INFORMATION CONTACT: Jonathan R. Zelnik, (202) 622–3930 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Sections 163(e) and 1271 through 1275 of the Internal Revenue Code (Code) provide rules for the treatment of debt instruments that have original issue discount (OID).

On February 2, 1994, the IRS and Treasury published in the Federal Register (59 F.R. 4799) final regulations under the OID provisions. On April 7, 1995, the IRS published in the Federal Register (60 F.R. 17731) a notice of proposed rulemaking relating to the federal income tax treatment of annuity contracts that are not

issued by insurance companies subject to tax under subchapter L of the Code. The proposed regulations treat certain of these annuity contracts as debt instruments for purposes of the OID provisions.

The IRS received a number of written comments on the proposed regulations. In addition, on August 8, 1995, the IRS held a public hearing on the proposed regulations. The proposed regulations, with certain changes in response to comments, are adopted as final regulations. The comments and changes are discussed below.

Explanation of Provisions

Certain Annuity Contracts

The OID provisions generally apply to issuers and holders of debt instruments. The term debt instrument means any instrument or contractual arrangement that constitutes indebtedness under general principles of federal income tax law. See section 1275(a)(1) and §1.1275–1(d).

Section 1275(a)(1)(B) excepts two types of annuity contracts from the definition of debt instrument (and, therefore, from the OID provisions). First, section 1275(a)(1)(B)(i) excepts an annuity contract to which section 72 applies if the contract “depends (in whole or in substantial part) on the life expectancy of 1 or more individuals.” Second, section 1275(a)(1)(B)(ii) excepts an annuity contract to which section 72 applies if the contract is issued by “an insurance company subject to tax under subchapter L” and the circumstances of the contract’s issuance meet certain criteria.

The proposed regulations address only the first exception, which is contained in section 1275(a)(1)(B)(i). Under the proposed regulations, an annuity contract qualifies for the exception in section 1275(a)(1)(B)(i) only if all payments under the contract are periodic payments that: (1) are made at least annually for the life (or lives) of one or more individuals; (2) do not increase at any time during the life of the contract; and (3) are part of a series of payments that begins within one year of the date of the initial investment in the contract. An annuity contract that is otherwise described in the preceding sentence, however, does not fail to qualify for the exception in section 1275(a)

1998–10 I.R.B. 15 March 9, 1998

utions made at least annually for the life (or joint lives) of an individual (or a reasonable number of individuals); and (2) contains no terms or provisions that can significantly reduce the probability that total distributions will increase commensurately with longevity.

The final regulations identify several types of terms and provisions that can significantly reduce the probability that total distributions under the contract will increase commensurately with longevity. These terms and provisions include the availability of a cash surrender option, the availability of a loan secured by the contract, minimum payout provisions, maximum payout provisions, and provisions that allow decreasing payouts. Subject to limited exceptions, the presence of any of these terms or provisions causes an annuity contract to fail to qualify for the exception in section 1275(a)(1)(B)(i). The list of identified terms and provisions in the final regulations is not exclusive. A contract fails to qualify for the exception in section 1275(a)(1)(B)(i) if the contract contains any other term or provision that can significantly reduce the probability that total distributions under the contract will increase commensurately with longevity.

Cash Surrender Options and Loans Secured by the Contract

If the holder of an annuity contract can exchange or surrender all or part of the contract for a distribution or for distributions that are not contingent on life, the holder’s decision whether, and when, to exchange or surrender the contract can render the life contingency insignificant. Similarly, if the holder of an annuity contract can borrow against the contract, the holder’s decision whether, and when, to borrow can have a comparable effect. The final regulations, therefore, provide that, if either the issuer or a person acting in concert with the issuer explicitly or implicitly makes available either a cash surrender option or a loan secured by the contract, then the contract contains a term that can significantly reduce the probability that total distributions on the contract will increase commensurately with longevity. That availability, therefore, causes the contract to fail to qualify for the exception in section 1275(a)(1)(B)(i).

Minimum Payout Provisions

If an annuity contract guarantees that a minimum amount will be distributed regardless of the death of the individual (or individuals) over whose life (or lives) payments are to be made, the minimum amount is not subject to the life contingency. In addition, the larger the minimum amount relative to aggregate expected distributions over the remaining (joint) life expectancy of the annuitant (or annuitants), the less likely it is that total distributions under the contract will increase commensurately with the longevity of the annuitant (or annuitants). A sufficiently large minimum amount renders the life contingency virtually meaningless. For example, consider a contract that provides for monthly distributions to begin on the annuity starting date and to extend for the longer of the life of the annuitant or 20 years, regardless of the annuitant’s age. If the annuitant has a life expectancy as of the annuity starting date of 5 years, it is likely that distributions will be made for exactly 20 years, regardless of when the annuitant dies. In this case, although the form of the contract indicates that it depends on life, the existence of the minimum payout provision significantly reduces the probability that total distributions under the contract will depend on longevity.

Because the existence of a minimum payout provision can significantly reduce the probability that total distributions under the contract will increase commensurately with longevity, the existence of any such provision generally causes the contract to fail to qualify for the exception in section 1275(a)(1)(B)(i). The final regulations provide only two exceptions to this general rule. First, an annuity contract does not fail to be described in section 1275(a)(1)(B)(i) merely because it contains a minimum payout provision that guarantees a death benefit no greater than the unrecovered consideration paid for the contract. Second, an annuity contract does not fail to be described in section 1275(a)(1)(B)(i) merely because the contract provides that, after annuitization, distributions may be guaranteed to continue for a term certain that is no longer than one-half of the period of time from the annuity starting date to the expected date of the “terminating death.”

The terminating death is the annuitant death that, in general, causes annuity payments to cease under the contract. The expected date of the terminating death is determined as of the annuity starting date with respect to all then-surviving annuitants by reference to the applicable mortality table prescribed under section 417(e)(3)(A)(ii)(I). See Rev. Rul. 95–6, 1995–1 C.B. 80, for the applicable mortality table that is prescribed for this purpose as of January 8, 1998.

Maximum Payout Provisions

If an annuity contract provides that distributions will cease if an annuitant lives beyond a specified date, total distributions under the contract may fail to increase commensurately with longevity. If the specified date is relatively early (when compared to the annuitant’s life expectancy as of the annuity starting date), its existence significantly reduces the probability that total distributions under the contract will increase commensurately with longevity. Conversely, if the specified date is very late (when compared to the annuitant’s life expectancy as of the annuity starting date), its existence does not significantly reduce the probability that total distributions under the contract will increase commensurately with longevity. For example, consider an annuity contract that provides that distributions will be made for the life of the annuitant but in no event for more than 30 years. If the annuitant is a relatively young person, this maximum payout provision significantly attenuates the life contingency. On the other hand, if the annuitant has a life expectancy of 10 years on the annuity starting date, this maximum payout provision is unlikely to determine the total distributions.

Because the existence of a maximum payout provision can significantly reduce the probability that total distributions under the contract will increase commensurately with longevity, the final regulations provide that the existence of any maximum payout provision generally causes the contract to fail to qualify for the exception in section 1275(a)(1)(B)(i). There is a single exception to this general rule in cases where the period of time between the annuity starting date and the date after which (under the maximum pay

March 9, 1998 16 1998–10 I.R.B.

arrangement is not subject to the OID timing provisions. See also §§1.1273–2(d) and 1.1274–1(a), under which a nonpublicly traded debt instrument issued for services has an issue price equal to its stated redemption price at maturity and, therefore, has no OID.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. Because the notice of proposed rulemaking preceding the regulations was issued prior to March 29, 1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking was submitted to the Small Business Administration for comment on its impact on small business.

Drafting Information

Several persons from the Office of Chief Counsel and the Treasury department participated in developing these regulations.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by removing the entries for “Sections 1.1271–1 through 1.1274– 5” and “Sections 1.1275–1 through 1.1275–5” and adding the following entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.1271–1 also issued under 26 U.S.C. 1275(d). Section 1.1272–1 also issued under 26 U.S.C. 1275(d). Section 1.1272–2 also issued under 26 U.S.C. 1275(d). Section 1.1272–3 also issued under 26 U.S.C. 1275(d). Section 1.1273–1 also issued under 26

out provision) no distributions will be made is at least twice as long as the period of time from the annuity starting date to the expected date of the terminating death.

Decreasing Payout Provisions

The connection between longevity and distributions under an annuity contract is apparent in the case of a contract that provides for equal annual distributions for life. For each year the annuitant lives, another equal distribution is made. If distributions decrease over time, this connection can become attenuated. Consider an annuity contract that provides for a distribution upon annuitization of $100,000 followed by annual distributions of $10 per year for life. Although this contract provides for periodic distributions for life, the pattern of the distributions causes the amount distributed to fail to adequately reflect longevity.

If the amount of distributions under an annuity contract during any contract year may be less than the amount of distributions during the preceding year, the final regulations provide that this possibility can significantly reduce the probability that total distributions under the contract will increase commensurately with longevity. Thus, the existence of this possibility generally causes the contract to fail to qualify for the exception in section 1275(a)(1)(B)(i). There is a single exception to this general rule for certain variable distributions that are closely tied to investment experience, inflation, or similar fluctuating criteria. In these cases, because the provision can result in comparable increases in the amount of distributions, the possibility that the distributions may decline from year to year does not significantly reduce the probability that total distributions under the contract will increase commensurately with longevity.

Private and Charitable Gift Annuity Contracts

Several commentators expressed concerns that the proposed regulations, if finalized, would alter the tax treatment traditionally afforded private and charitable gift annuity contracts. Private annuity contracts are typically issued as consideration in intra-family transfers of property. Charitable gift annuity contracts are typi

cally issued by charitable institutions in exchange for a transfer of cash or property greater in value than the annuity. Because these contracts may call for periodic distributions to begin more than one year after they are issued, there was concern that, under the proposed regulations, they might fail to qualify for the exception in section 1275(a)(1)(B)(i).

In many cases, distributions under private and charitable gift annuity contracts are entirely contingent on the survival of one individual (or a small number of individuals). These contracts are not indebtedness under general principles of federal income tax law and, therefore, are not within the definition of debt instrument in section 1275(a)(1)(A). For almost all other private and charitable gift annuities, the final regulations address the concern by removing the requirement that the distributions begin within one year of the date of the initial investment in the contract.

Annuity Contracts Issued by Foreign Insurance Companies

One commentator asked the IRS to clarify the treatment of annuity contracts issued by a foreign insurance company that does not engage in a trade or business within the United States. In particular, the commentator asked for guidance on whether such an annuity contract qualifies under section 1275(a)(1)(B)(ii), which provides a broad exception from the definition of debt instrument for certain annuity contracts issued by “an insurance company subject to tax under subchapter L.” These regulations do not address the exception in section 1275(a)(1)(B)(ii). The Treasury and the IRS, however, welcome comments on the proper scope of that provision.

Certain Compensation Arrangements

Several commentators questioned whether the proposed regulations apply to certain compensation arrangements whose distributions are taxed under section 72. The timing rules of the OID provisions do not apply to compensation arrangements that are subject to other specific Code or regulations provisions. For example, if an arrangement is described in the first sentence of section 404(a) or in section 404(b) or if amounts under the arrangement are includible under sections 83, 403, or 457, or under §1.61–2, the

1998–10 I.R.B. 17 March 9, 1998

U.S.C. 1275(d). Section 1.1273–2 also issued under 26 U.S.C. 1275(d). Section 1.1274–1 also issued under 26 U.S.C. 1275(d). Section 1.1274–2 also issued under 26 U.S.C. 1275(d). Section 1.1274–3 also issued under 26 U.S.C. 1275(d). Section 1.1274–4 also issued under 26 U.S.C. 1275(d). Section 1.1274–5 also issued under 26 U.S.C. 1275(d). * * * Section 1.1275–1 also issued under 26 U.S.C. 1275(d). Section 1.1275–2 also issued under 26 U.S.C. 1275(d). Section 1.1275–3 also issued under 26 U.S.C. 1275(d). Section 1.1275–4 also issued under 26 U.S.C. 1275(d). Section 1.1275–5 also issued under 26 U.S.C. 1275(d). * * *

Par. 2. Section 1.1271–0 is amended by adding entries for paragraphs (i) through (j)(8) to §1.1275–1 to read as follows:

§1.1271–0 Original issue discount; effective dates; table of contents.

§1.1275–1 Definitions.

tions under the contract. (See paragraph (j)(2)(i)(A) of this section.) For example, if a contract provides for periodic distributions until the later of the death of the last-surviving annuitant or the end of a term certain, the terminating death is the death of the last-surviving annuitant.

(iii) Coordination with specific rules. Paragraphs (j)(3) through (7) of this section describe certain terms and conditions that can significantly reduce the probability that total distributions under the contract will increase commensurately with the longevity of the annuitant (or annuitants). If a term or provision is not specifically described in paragraphs (j)(3) through (7) of this section, the annuity contract must be tested under the general rule of paragraph (j)(2)(i) of this section to determine whether it depends (in whole or in substantial part) on the life expectancy of one or more individuals.

(3) Availability of a cash surrender op- tion —(i) Impact on life contingency. The availability of a cash surrender option can significantly reduce the probability that total distributions under the contract will increase commensurately with the longevity of the annuitant (or annuitants). Thus, the availability of any cash surrender option causes the contract to fail to be described in section 1275(a)(1)(B)(i). A cash surrender option is available if there is reason to believe that the issuer (or a person acting in concert with the issuer) will be willing to terminate or purchase all or a part of the annuity contract by making one or more payments of cash or property (other than an annuity contract described in this paragraph (j)).

(ii) Examples. The following examples illustrate the rules of this paragraph (j)(3):

Example 1 . (i) Facts. On March 1, 1998, X issues a contract to A for cash. The contract provides that, effective on any date chosen by A (the annuity starting date), X will begin equal monthly distributions for A’s life. The amount of each monthly distribution will be no less than an amount based on the contract’s account value as of the annuity starting date, A’s age on that date, and permanent purchase rate guarantees contained in the contract. The contract also provides that, at any time before the annuity starting date, A may surrender the contract to X for the account value less a surrender charge equal to a declining percentage of the account value. For this purpose, the initial account value is equal to the cash invested. Thereafter, the account value increases annually by at least a minimum guaranteed rate.

(ii) Analysis. The ability to obtain the account value less the surrender charge, if any, is a cash surrender option. This ability can significantly reduce

(i) [Reserved] (j) Life annuity exception under section 1275(a)(1)(B)(i). (1) Purpose. (2) General rule. (3) Availability of a cash surrender option.

(4) Availability of a loan secured by the contract.

(5) Minimum payout provision. (6) Maximum payout provision. (7) Decreasing payout provision. (8) Effective dates.

Par. 3. Section 1.1275–1 is amended by:

Revising the first sentence of paragraph (d).
Adding and reserving paragraph (i).
Adding paragraph (j). The revision and additions read as follows:

§1.1275–1 Definitions.

(d) Debt instrument. Except as provided in section 1275(a)(1)(B) (relating to certain annuity contracts; see paragraph (j) of this section), debt instrument means any instrument or contractual arrangement that constitutes indebtedness under general principles of Federal income tax law (including, for example, a certificate of deposit or a loan). * * *

(i) [Reserved] (j) Life annuity exception under section 1275(a)(1)(B)(i) —(1) Purpose. Section 1275(a)(1)(B)(i) excepts an annuity contract from the definition of debt instru- ment if section 72 applies to the contract and the contract depends (in whole or in substantial part) on the life expectancy of one or more individuals. This paragraph (j) provides rules to ensure that an annuity contract qualifies for the exception in section 1275(a)(1)(B)(i) only in cases where the life contingency under the contract is real and significant.

(2) General rule —(i) Rule. For purposes of section 1275(a)(1)(B)(i), an annuity contract depends (in whole or in substantial part) on the life expectancy of one or more individuals only if—

(A) The contract provides for periodic distributions made not less frequently than annually for the life (or joint lives) of an individual (or a reasonable number of individuals); and

(B) The contract does not contain any terms or provisions that can significantly reduce the probability that total distributions under the contract will increase commensurately with the longevity of the annuitant (or annuitants).

(ii) Terminology. For purposes of this paragraph (j):

(A) Contract. The term contract includes all written or unwritten understandings among the parties as well as any person or persons acting in concert with one or more of the parties.

(B) Annuitant. The term annuitant refers to the individual (or reasonable number of individuals) referred to in paragraph (j)(2)(i)(A) of this section.

(C) Terminating death. The phrase ter- minating death refers to the annuitant death that can terminate periodic distribu

March 9, 1998 18 1998–10 I.R.B.

spect to all then-surviving annuitants. The expected date of the terminating death must be determined by reference to the applicable mortality table prescribed under section 417(e)(3)(A)(ii)(I).

(iv) Examples. The following examples illustrate the rules of this paragraph (j)(5):

Example 1. (i) Facts. On March 1, 1998, X issues a contract to D for cash. The contract provides that, effective on any date D chooses (the annuity starting date), X will begin equal monthly distributions for the greater of D’s life or 10 years, regardless of D’s age as of the annuity starting date. The amount of each monthly distribution will be no less than an amount based on the contract’s account value as of the annuity starting date, D’s age on that date, and permanent purchase rate guarantees contained in the contract.

(ii) Analysis. A minimum payout provision exists because, if D dies within 10 years of the annuity starting date, one or more distributions will be made after D’s death. The minimum payout provision does not qualify for the exception in paragraph (j)(5)(iii)(B) of this section because D may defer the annuity starting date until his remaining life expectancy is less than 20 years. If, on the annuity starting date, D’s life expectancy is less than 20 years, the minimum payout period (10 years) will last beyond the halfway date. The minimum payout provision, therefore, can significantly reduce the probability that total distributions under the contract will increase commensurately with D’s longevity. Thus, the contract fails to be described in section 1275(a)(1)(B)(i). Example 2. (i) Facts. The facts are the same as in Example 1 of this paragraph (j)(5)(iv) except that the monthly distributions will last for the greater of D’s life or a term certain. D may choose the length of the term certain subject to the restriction that, on the annuity starting date, the term certain must not exceed one-half of D’s life expectancy as of the annuity starting date. The contract also does not provide for any adjustment in the amount of distributions by reason of the death of D or any other individual, except for a refund of D’s aggregate premium payments less the sum of all prior distributions under the contract.

(ii) Analysis. The minimum payout provision qualifies for the exception in paragraph (j)(5)(iii)(B) of this section because distributions under the minimum payout provision will not continue past the halfway date and the contract does not provide for any adjustments in the amount of distributions by reason of the death of D or any other individual, other than a guaranteed death benefit described in paragraph (j)(5)(iii)(A) of this section. Accordingly, the existence of this minimum payout provision does not prevent the contract from being described in section 1275(a)(1)(B)(i).

(6) Maximum payout provision —(i) Impact on life contingency. The existence of a maximum payout provision can significantly reduce the probability that total distributions under the contract will increase commensurately with the

the probability that total distributions under the contract will increase commensurately with A’s longevity. Thus, the contract fails to be described in section 1275(a)(1)(B)(i).

Example 2 . (i) Facts . On March 1, 1998, X issues a contract to B for cash. The contract provides that beginning on March 1, 1999, X will distribute to B a fixed amount of cash each month for B’s life. Based on X’s advertisements, marketing literature, or illustrations or on oral representations by X’s sales personnel, there is reason to believe that an affiliate of X stands ready to purchase B’s contract for its commuted value.

(ii) Analysis. Because there is reason to believe that an affiliate of X stands ready to purchase B’s contract for its commuted value, a cash surrender option is available within the meaning of paragraph (j)(3)(i) of this section. This availability can significantly reduce the probability that total distributions under the contract will increase commensurately with B’s longevity. Thus, the contract fails to be described in section 1275(a)(1)(B)(i).

(4) Availability of a loan secured by the contract —(i) Impact on life contin- gency. The availability of a loan secured by the contract can significantly reduce the probability that total distributions under the contract will increase commensurately with the longevity of the annuitant (or annuitants). Thus, the availability of any such loan causes the contract to fail to be described in section 1275(a)(1)(B)(i). A loan secured by the contract is available if there is reason to believe that the issuer (or a person acting in concert with the issuer) will be willing to make a loan that is directly or indirectly secured by the annuity contract.

(ii) Example. The following example illustrates the rules of this paragraph (j)(4):

Example. (i) Facts. On March 1, 1998, X issues a contract to C for $100,000. The contract provides that, effective on any date chosen by C (the annuity starting date), X will begin equal monthly distributions for C’s life. The amount of each monthly distribution will be no less than an amount based on the contract’s account value as of the annuity starting date, C’s age on that date, and permanent purchase rate guarantees contained in the contract. From marketing literature circulated by Y, there is reason to believe that, at any time before the annuity starting date, C may pledge the contract to borrow up to $75,000 from Y. Y is acting in concert with X.

(ii) Analysis. Because there is reason to believe that Y, a person acting in concert with X, is willing to lend money against C’s contract, a loan secured by the contract is available within the meaning of paragraph (j)(4)(i) of this section. This availability can significantly reduce the probability that total distributions under the contract will increase commensurately with C’s longevity. Thus, the contract fails to be described in section 1275(a)(1)(B)(i).

(5) Minimum payout provision —(i) Im-

pact on life contingency. The existence of a minimum payout provision can significantly reduce the probability that total distributions under the contract will increase commensurately with the longevity of the annuitant (or annuitants). Thus, the existence of any minimum payout provision causes the contract to fail to be described in section 1275(a)(1)(B)(i).

(ii) Definition of minimum payout pro- vision. A minimum payout provision is a contractual provision (for example, an agreement to make distributions over a term certain) that provides for one or more distributions made—

(A) After the terminating death under the contract; or

(B) By reason of the death of any individual (including distributions triggered by or increased by terminal or chronic illness, as defined in section 101(g)(1)(A) and (B)).

(iii) Exceptions for certain minimum payouts —(A) Recovery of consideration paid for the contract. Notwithstanding paragraphs (j)(2)(i)(A) and (j)(5)(i) of this section, a contract does not fail to be described in section 1275(a)(1)(B)(i) merely because it provides that, after the terminating death, there will be one or more distributions that, in the aggregate, do not exceed the consideration paid for the contract less total distributions previously made under the contract.

(B) Payout for one-half of life ex- pectancy. Notwithstanding paragraphs (j)(2)(i)(A) and (j)(5)(i) of this section, a contract does not fail to be described in section 1275(a)(1)(B)(i) merely because it provides that, if the terminating death occurs after the annuity starting date, distributions under the contract will continue to be made after the terminating death until a date that is no later than the halfway date. This exception does not apply unless the amounts distributed in each contract year will not exceed the amounts that would have been distributed in that year if the terminating death had not occurred until the expected date of the terminating death, determined under paragraph (j)(5)(iii)(C) of this section.

(C) Definition of halfway date. For purposes of this paragraph (j)(5)(iii), the halfway date is the date halfway between the annuity starting date and the expected date of the terminating death, determined as of the annuity starting date, with re

1998–10 I.R.B. 19 March 9, 1998

longevity of the annuitant (or annuitants). Thus, the existence of any maximum payout provision causes the contract to fail to be described in section 1275(a)(1)(B)(i).

(ii) Definition of maximum payout pro- vision. A maximum payout provision is a contractual provision that provides that no distributions under the contract may be made after some date (the termination date), even if the terminating death has not yet occurred.

(iii) Exception. Notwithstanding paragraphs (j)(2)(i)(A) and (j)(6)(i) of this section, an annuity contract does not fail to be described in section 1275(a)(1)(B)(i) merely because the contract contains a maximum payout provision, provided that the period of time from the annuity starting date to the termination date is at least twice as long as the period of time from the annuity starting date to the expected date of the terminating death, determined as of the annuity starting date, with respect to all then-surviving annuitants. The expected date of the terminating death must be determined by reference to the applicable mortality table prescribed under section 417(e)(3)(A)(ii)(I).

(iv) Example. The following example illustrates the rules of this paragraph (j)(6):

Example . (i) Facts. On March 1, 1998, X issues a contract to E for cash. The contract provides that beginning on April 1, 1998, X will distribute to E a fixed amount of cash each month for E’s life but that no distributions will be made after April 1, 2018. On April 1, 1998, E’s life expectancy is 9 years.

(ii) Analysis. A maximum payout provision exists because if E survives beyond April 1, 2018, E will receive no further distributions under the contract. The period of time from the annuity starting date (April 1, 1998) to the termination date (April 1, 2018) is 20 years. Because this 20–year period is more than twice as long as E’s life expectancy on April 1, 1998, the maximum payout provision qualifies for the exception in paragraph (j)(6)(iii) of this section. Accordingly, the existence of this maximum payout provision does not prevent the contract from being described in section 1275(a)(1)(B)(i).

(7) Decreasing payout provision —(i) General rule. If the amount of distributions during any contract year (other than the last year during which distributions are made) may be less than the amount of distributions during the preceding year, this possibility can significantly reduce the probability that total distributions under the contract will increase commensurately with the longevity of the annuitant (or annuitants). Thus, the existence

of this possibility causes the contract to fail to be described in section 1275(a)(1)(B)(i).

(ii) Exception for certain variable dis- tributions. Notwithstanding paragraph (j)(7)(i) of this section, if an annuity contract provides that the amount of each distribution must increase and decrease in accordance with investment experience, cost of living indices, or similar fluctuating criteria, then the possibility that the amount of a distribution may decrease for this reason does not significantly reduce the probability that the distributions under the contract will increase commensurately with the longevity of the annuitant (or annuitants).

(iii) Examples. The following examples illustrate the rules of this paragraph (j)(7):

Example 1. (i) Facts. On March 1, 1998, X issues a contract to F for $100,000. The contract provides that beginning on March 1, 1999, X will make distributions to F each year until F’s death. Prior to March 1, 2009, distributions are to be made at a rate of $12,000 per year. Beginning on March 1, 2009, distributions are to be made at a rate of $3,000 per year.

(ii) Analysis. If F is alive in 2009, the amount distributed in 2009 ($3,000) will be less than the amount distributed in 2008 ($12,000). The exception in paragraph (j)(7)(ii) of this section does not apply. The decrease in the amount of any distributions made on or after March 1, 2009, can significantly reduce the probability that total distributions under the contract will increase commensurately with F’s longevity. Thus, the contract fails to be described in section 1275(a)(1)(B)(i).

Example 2. (i) Facts. On March 1, 1998, X issues a contract to G for cash. The contract provides that, effective on any date G chooses (the annuity starting date), X will begin monthly distributions to G for G’s life. Prior to the annuity starting date, the account value of the contract reflects the investment return, including changes in the market value, of an identifiable pool of assets. When G chooses the annuity starting date, G must also choose whether the distributions are to be fixed or variable. If fixed, the amount of each monthly distribution will remain constant at an amount that is no less than an amount based on the contract’s account value as of the annuity starting date, G’s age on that date, and permanent purchase rate guarantees contained in the contract. If variable, the monthly distributions will fluctuate to reflect the investment return, including changes in the market value, of the pool of assets. The monthly distributions under the contract will not otherwise decline from year to year.

(ii) Analysis. Because the only possible year-toyear declines in annuity distributions are described in paragraph (j)(7)(ii) of this section, the possibility that the amount of distributions may decline from the previous year does not reduce the probability that total distributions under the contract will increase commensurately with G’s longevity. Thus, the potential fluctuation in the annuity distributions

does not cause the contract to fail to be described in section 1275(a)(1)(B)(i).

(8) Effective dates —(i) In general. Except as provided in paragraph (j)(8)(ii) and (iii) of this section, this paragraph (j) is applicable for interest accruals on or after February 9, 1998 on annuity contracts held on or after February 9, 1998.

(ii) Grandfathered contracts. This paragraph (j) does not apply to an annuity contract that was purchased before April 7, 1995. For purposes of this paragraph (j)(8), if any additional investment in such a contract is made on or after April 7, 1995, and the additional investment is not required to be made under a binding contractual obligation that was entered into before April 7, 1995, then the additional investment is treated as the purchase of a contract after April 7, 1995.

(iii) Contracts consistent with the pro- visions of FI–33–94, published at 1995–1 C.B. 920. See § 601.601(d)(2)(ii)(b) of this chapter. This paragraph (j) does not apply to a contract purchased on or after April 7, 1995, and before February 9, 1998, if all payments under the contract are periodic payments that are made at least annually for the life (or lives) of one or more individuals, do not increase at any time during the term of the contract, and are part of a series of distributions that begins within one year of the date of the initial investment in the contract. An annuity contract that is otherwise described in the preceding sentence does not fail to be described therein merely because it also provides for a payment (or payments) made by reason of the death of one or more individuals.

Michael P. Dolan, Deputy Commissioner of

Internal Revenue.

Approved December 19, 1997.

Donald C. Lubick, Acting Assistant Secretary of

the Treasury .

(Filed by the Office of the Federal Register on January 7, 1998, 8:45 a.m., and published in the issue of the Federal Register for January 8, 1998, 63 F.R. 1054)

Section 1288.—Treatment of Original Issue Discount on Tax- Exempt Obligations

March 9, 1998 20 1998–10 I.R.B.

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 1397E.—Credit to Holders of Qualified Zone Academy Bonds

26 CFR 1.1397E–1T: Qualified Zone Academy Bonds (temporary).

T.D. 8755

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Qualified Zone Academy Bonds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains temporary regulations relating to the federal income tax treatment of qualified zone academy bonds. The regulations in this document provide needed guidance to holders and issuers of qualified zone academy bonds. The text of the temporary regulations also serves as the text of REG–119449–97, page 35 of this Bulletin.

DATES: These regulations are effective January 1, 1998.

FOR FURTHER INFORMATION CONTACT: Timothy L. Jones, (202) 6223980 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Section 226(a) of the Taxpayer Relief Act of 1997, Pub. L. No. 105–34, 111 Stat. 788 (1997), amended the Internal Revenue Code (Code) by redesignating section 1397E as section 1397F and adding a new section 1397E. Section 1397E authorizes a new type of debt instrument known as a qualified zone academy bond.

Explanation of provisions

In general

A qualified zone academy bond is a

taxable bond issued by a state or local government the proceeds of which are used to improve certain eligible public schools. In lieu of receiving periodic interest payments from the issuer, an eligible holder of a qualified zone academy bond is generally allowed annual federal income tax credits while the bond is outstanding. These credits compensate the holder for lending money to the issuer and function as payments of interest on the bond.

These temporary regulations provide rules for the federal income tax treatment of qualified zone academy bonds. These regulations generally treat the allowance of the credit as if it were a payment of interest on the bond. These regulations also provide rules to determine (1) the credit rate, (2) the discount rate used to present value private business contributions, and (3) the discount rate used to determine the maximum term of a qualified zone academy bond.

These regulations generally do not provide guidance on the statutory requirements that must be met for a bond to qualify as a qualified zone academy bond. Section 1397E(d) sets forth a number of detailed requirements that must be met for a bond to qualify as a qualified zone academy bond. In particular, section 1397E(d)(1)(C) requires the issuer to certify (1) that it has written assurances that private entities have agreed to contribute a certain level of goods or services to the qualified zone academy, and (2) that it has the written approval of the eligible local education agency for the bond issuance. The Treasury and the IRS intend that these certifications will be respected and may be relied on by taxpayers if the certifications are reasonably made.

In addition, section 1397E(d)(1)(A) requires that 95 percent or more of the proceeds of an issue of qualified zone academy bonds are to be used for a qualified purpose described in section 1397E(d)(5) with respect to a qualified zone academy as defined in section 1397E(d)(4). The Treasury and the IRS intend that the qualified purposes set forth in section 1397E(d)(5) are to be broadly interpreted. The Treasury and the IRS also intend that, if an issuer is unable to actually spend 95 percent or more of the proceeds of a qualified zone academy bond for a qualified purpose, the issuer may apply remedial

actions similar to the remedial actions set forth in §1.142–2 to preserve the qualification of a bond. Further, the Treasury and the IRS intend that taxpayers may rely on an issuer’s determination that a public school (or academic program within a public school) is a qualified zone academy for purposes of section 1397E(d)(4) if the determination has a reasonable basis. The Treasury and IRS request comments on whether additional guidance is needed with respect to the section 1397E(d) requirements.

Section 1397E(e) imposes a national limitation on the amount of qualified zone academy bonds that can be issued. For 1998 and 1999, the IRS will publish a revenue procedure allocating the national limitation among the States and the possessions.

The credit allowance

A qualified zone academy bond provides an annual federal income tax credit to certain holders. Under the regulations, the credit is deemed paid on the credit al- lowance date —the last day of each oneyear accrual period on the bond. A taxpayer that receives a credit on a credit allowance date may use the credit to offset its income tax liability for the taxable year that includes the credit allowance date.

There are two limitations on the use of the credit. First, only eligible taxpayers holding the bond on the credit allowance date may claim the credit. Section 1397E(d)(6) defines an eligible taxpayer as a bank, an insurance company, or a corporation actively engaged in the business of lending money. Second, an eligible taxpayer may claim the credit only to the extent the taxpayer has a tax liability for the taxable year that includes the credit allowance date. See section 1397E(c). The credit is nonrefundable.

Treatment of the credit as interest

The regulations treat the credit on a qualified academy zone bond as if it were a payment of qualified stated interest. This treatment effectively conforms the treatment of the credit with the treatment of interest income on debt instruments. Thus, for example, a holder that uses an accrual method of accounting accrues the credit amount over the one-year accrual period that ends on the credit allowance date.

1998–10 I.R.B. 21 March 9, 1998

Adjustment when credit is limited or disallowed

In two situations the holder of a qualified zone academy bond on a credit allowance date will not be able to use some or all of the credit to offset its tax liability. First, if the holder on a credit allowance date is not an eligible taxpayer (a bank, insurance company, or corporation actively engaged in the business of lending money), no credit is allowed. Second, the amount of the credit may exceed the income tax liability of a holder that is an eligible taxpayer. In this second case, because the credit is nonrefundable, some or all of the credit will not be used.

In these situations, the regulations allow the holder to adjust its income by deducting the amount of the unused credit. This deduction is allowed for the taxable year that includes the credit allowance date. The Treasury and the IRS request comments on whether this adjustment works appropriately when an eligible taxpayer holds a qualified zone academy bond on the credit allowance date but has an income tax liability (determined without regard to the credit) that is less than the amount of the credit.

Credit rate

Section 1397E(b)(2) authorizes the Treasury to establish a single, uniform credit rate that will permit the issuance of qualified zone academy bonds without discount and without interest cost to the issuer. This section also requires the Treasury to adjust the credit allowance rate on a monthly basis to reflect changes in market interest rates.

It is not possible to determine a uniform credit rate that would permit all qualified zone academy bonds to be issued at par. Some borrowers are less creditworthy than others and, therefore, borrow at less favorable rates. In addition, because section 1397E(b)(2) requires the Secretary to set the credit rate in the month before the bond is issued, changes in market interest rates between the time the rate is set and the time a qualified zone academy bond is issued can result in a bond being issued at a price that is different than par.

The regulations provide a single monthly rate that will minimize the discount or premium on qualified zone academy bonds.

Specifically, the regulations provide that the credit rate is 110 percent of the longterm applicable Federal rate (AFR), compounded annually, for the month of issuance. Tying the credit rate to the AFR ensures that the rate will be adjusted on a monthly basis to reflect changes in market interest rates. In addition, the Treasury and the IRS believe the 10 percent spread over the long-term AFR is appropriate, in part, because qualified zone academy bonds bear more credit and liquidity risk than longterm Treasury bonds.

Maximum term

Section 1397E(d)(3) sets out a formula for determining the maximum term of a qualified zone academy bond. The formula requires the use of a discount rate equal to the average annual interest rate of tax-exempt obligations having a term of ten years or more. Because there is no readily available source for this discount rate, the regulations provide that the discount rate is 110 percent of the long-term adjusted AFR, compounded semi-annually. The long-term adjusted AFR is published on a monthly basis and is designed to reflect the current yield of a risk-free tax-exempt obligation having a term of 9 years or more.

Taxable obligation

It is possible that some qualified zone academy bonds may either (1) provide for payments of stated interest, or (2) be issued at a discount. The Treasury and the IRS have determined that qualified zone academy bonds are not obligations the interest on which is excluded from gross income under section 103(a). There are a number of reasons for treating a qualified zone academy bond as a taxable obligation. For example, the requirement in section 1397E(g) that a holder include the allowed amount of the credit in gross income evidences an intention to treat qualified zone academy bonds as taxable, not tax-exempt, obligations.

Coordination with estimated tax rules

The regulations do not address the estimated tax consequences of holding a qualified zone academy bond. The Treasury and the IRS request comments on whether there is a need to coordinate the regulations with the estimated tax rules

and, if so, how they might be coordinated.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

Several persons from the Office of Chief Counsel and the Treasury Department participated in developing these regulations.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.1397E–1T also issued under 26 U.S.C. 1397E(b) and 1397E(d). * * * Par. 2. Section 1.1397E–1T is added to read as follows:

§1.1397E–1T Qualified zone academy bonds (temporary).

(a) Overview. In general, a qualified zone academy bond is a taxable bond issued by a state or local government the proceeds of which are used to improve certain eligible public schools. An eligible taxpayer that holds a qualified zone academy bond generally is allowed annual federal income tax credits in lieu of periodic interest payments. These credits compensate the eligible taxpayer for lending money to the issuer and function as

March 9, 1998 22 1998–10 I.R.B.

payments of interest on the bond. Accordingly, this section generally treats the allowance of a credit as if it were a payment of interest on the bond. In addition, this section provides rules to determine the credit rate, the present value of qualified contributions from private entities, and the maximum term of a qualified zone academy bond.

(b) Credit rate. The credit rate for a qualified zone academy bond is equal to 110 percent of the long-term applicable Federal rate (AFR), compounded annually, for the month in which the bond is issued. The Internal Revenue Service publishes this figure each month in a revenue ruling that is published in the Internal Revenue Bulletin. See §601.601(d)(2)(ii)(b) of this Chapter.

(c) Private business contribution re- quirement. To determine the present value (as of the issue date) of qualified contributions from private entities under section 1397E(d)(2), the issuer must use a reasonable discount rate. The credit rate determined under paragraph (b) of this section is a reasonable discount rate.

(d) Maximum term. The maximum term for a qualified zone academy bond is determined under section 1397E(d)(3) by using a discount rate equal to 110 percent of the long-term adjusted AFR, compounded semi-annually, for the month in which the bond is issued. The Internal Revenue Service publishes this figure each month in a revenue ruling that is published in the Internal Revenue Bulletin. See §601.601(d)(2)(ii)(b) of this Chapter.

(e) Tax credit —(1) Eligible taxpayer. An eligible taxpayer (within the meaning of section 1397E(d)(6)) that holds a qualified zone academy bond on a credit allowance date is allowed a tax credit against the federal income tax imposed on the taxpayer for the taxable year that includes the credit allowance date. The amount of the credit is equal to the product of the credit rate and the outstanding principal amount of the bond on the credit allowance date. The credit is subject to a limitation based on the eligible taxpayer’s income tax liability. See section 1397E(c).

(2) Ineligible taxpayer. A taxpayer that is not an eligible taxpayer is not allowed a credit.

(f) Treatment of the allowance of the

credit as a payment of interest —(1) Gen- eral rule. The holder of a qualified zone academy bond must treat the bond as if it pays qualified stated interest (within the meaning of §1.1273–1(c)) on each credit allowance date. The amount of the deemed payment of interest on each credit allowance date is equal to the product of the credit rate and the outstanding principal amount of the bond on that date. Thus, for example, if the holder uses an accrual method of accounting, the holder must accrue as interest income the amount of the credit over the one-year accrual period that ends on the credit allowance date.

(2) Adjustment if the holder cannot use the credit to offset a tax liability. If a holder holds a qualified zone academy bond on the credit allowance date but cannot use all or a portion of the credit to reduce its income tax liability (for example, because the holder is not an eligible taxpayer or because the limitation in section 1397E(c) applies), the holder is allowed a deduction for the taxable year that includes the credit allowance date. The amount of the deduction is equal to the amount of the unused credit deemed paid on the credit allowance date.

(g) Not a tax-exempt obligation. A qualified zone academy bond is not an obligation the interest on which is excluded from gross income under section 103(a). (h) Cross-references. See section 171 and the regulations thereunder for rules relating to amortizable bond premium. See §1.61–7(c) for the seller’s treatment of a bond sold between interest payment dates (credit allowance dates) and §1.61– 7(d) for the buyer’s treatment of a bond purchased between interest payment dates (credit allowance dates).

(i) [Reserved] (j) Effective date. This section applies to a qualified zone academy bond issued on or after January 1, 1998.

Michael P. Dolan, Deputy Commissioner of

Internal Revenue.

Approved December 19, 1997.

Donald C. Lubick, Acting Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on January 6, 1998, 8:45 a.m., and published in the issue of the Federal Register for January 7, 1998, 63 F.R. 671)

Section 1502.—Regulations

26 CFR 1.1502–3: Consolidated investment credit.

T.D. 8751

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Consolidated Returns— Limitations on the Use of Certain Losses and Credits; Overall Foreign Loss Accounts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains temporary amendments to the consolidated return regulations. The temporary amendments govern the use of tax credits of a consolidated group and its members. They also concern the recharacterization of certain foreign source income because of a prior overall foreign loss. The text of the temporary regulations also serves as the text of REG–104062–97, page 34 in this Bulletin.

DATES: These amendments are effective January 12, 1998. For dates of application, see the Effective Dates portion of the preamble under SUPPLEMENTARY INFORMATION. FOR FURTHER INFORMATION CONTACT: Concerning the temporary regulations in general, Roy A. Hirschhorn, (202) 622-7770; concerning amendments related to foreign tax credits and foreign losses, Seth Goldstein (202) 622-3850.

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

A. In General

On June 27, 1996, the IRS and Trea

1998–10 I.R.B. 23 March 9, 1998

sury published in the Federal Register a Treasury decision containing temporary regulations which, in part, provide rules governing the absorption of certain tax attribute carryovers and carrybacks from separate return limitation years (SRLYs), terminate the consolidated return change of ownership rules, and make minor changes to the computation of net section 1231 gains and losses for a group. The Treasury decision adopted without substantive change rules that were proposed in 1991. The 1996 temporary regulations are effective for consolidated return years beginning on or after January 1, 1997.

The 1996 temporary regulations significantly modify SRLY loss rules which had been in place since 1966. The 1966 SRLY rules employed a member-by-member and year-by-year approach to determine the limitation on SRLY attributes. The 1996 temporary regulations adopted a subgroup and cumulative approach. See the preamble to NPRM for CO–078–90 (56 F.R. 4228), reprinted at 1991–1 C.B. 757. The 1996 temporary regulations, however, only apply the new approach to net operating loss and net capital loss carryovers and carrybacks. They do not change regulations containing limitations on the absorption of the following other tax attribute carryovers and carrybacks from SRLYs: general business credits (§1.1502–3), foreign tax credits (§1.1502–4), and overall foreign losses (OFLs) (§1.1502–9).

On December 30, 1992, the IRS and Treasury published in the Federal Regis- ter a notice of proposed rulemaking containing rules regarding a group’s computation of its alternative minimum tax and minimum tax credits. See 57 F.R. 62251, as corrected by 58 F.R. 8027, reprinted at 1993–1 C.B. 799. The proposed regulations (Prop. Reg. §1.1502–55) do not address the application of SRLY limitations to the minimum tax credit.

B. Extension of 1996 Principles

The IRS and Treasury believe that it is appropriate to apply a single set of SRLY principles to all attributes that are subject to SRLY limitations. Unnecessary complexity would result from applying different principles to different attributes. In addition, the IRS and Treasury believe that the subgroup and cumulative principles embodied in the 1996 temporary regula

C. Treatment of Foreiqn Tax Credits.

OFLs and SLLs

In considering the application of the new SRLY principles in the temporary

tions more appropriately reflect the use of attributes brought into a consolidated group by SRLY members than do the member-by-member and year-by-year rules of the 1966 regulations. Accordingly, this document extends the principles of the 1996 temporary regulations to the general business credit and the minimum tax credit. In doing so, the IRS and Treasury have not attempted to address the issues which some commentators have raised with respect to the application of the SRLY limitations in general. Rather, those issues will be addressed in connection with a review of comments received in response to the 1991 proposed regulations, the 1996 temporary regulations and to the temporary regulations contained in this document, prior to the expiration of the 1996 temporary regulations in 1999.

In general, a group may include a member’s SRLY credits in the applicable consolidated section 38 credit or minimum tax credit for a consolidated return year based on the member’s contributions to the consolidated section 38(c) or consolidated section 53(c) limitation for all consolidated return years. The contribution is based on the aggregate of the member’s share of the group’s tax liability for relevant years. Such share is measured under the principles of section 1552 and the percentage method under §1.1502– 33(d)(3), assuming a 100% allocation of any decreased tax liability. The contribution may be a negative number, for example, for a year in which the overall loss of the member offsets the income of other members. In the case of the minimum tax credit, the temporary regulations provide an adjustment to avoid double counting for years in which the SRLY member contributes to the group’s AMT liability.

This document also adds an example to §1.1502–21T(c)(1) and §1.1502–23T(b). The examples assist taxpayers in computing their cumulative registers by illustrating the concept of cumulative contribution to consolidated net capital gain and consolidated taxable income and the character of section 1231 items for purposes of the relevant registers.

regulations to credits in general, the IRS and Treasury considered extending these principles to foreign tax credits (FTCs), and to those losses associated with the FTC regime, namely, overall foreign losses (OFLs) and separate limitation losses (SLLs). The IRS and Treasury were concerned that continued application of the principles of the 1966 regulations (member-by-member and year-by-year) to these foreign attributes, and especially to OFL and SLL accounts, could lead to inappropriate results. Taxpayers might adopt structures in an attempt to achieve indefinite postponement of the recapture of SRLY OFLs and SLLs. Such postponement would frustrate the neutrality principle that the SRLY rules are intended to serve (i.e., that the decision to join a new affiliated group should generally be unaffected by considerations relating to the absorption of pre-affiliation attributes).

While it was clear that application of the 1966 principles to OFLs and SLLs should not continue, it was less clear that application of the subgroup and cumulative principles of the temporary regulations would address all concerns. The subgroup and cumulative principles are meant to more closely parallel the absorption that would have taken place had the member (or subgroup) continued filing separate returns. The interaction of the FTC regime (with its multiple baskets) and other provisions of the Internal Revenue Code affecting international transactions, such as, for example, section 864(e)(1) which allocates the interest expense of a member to income in various baskets based on the group’s asset allocation, can make it difficult to determine what the member has contributed to the group. Furthermore, even with the adoption of the subgroup and cumulative principles, taxpayers would likely have the ability to transfer controlled foreign corporations to new members or to cause operations to be assumed by new members, thereby delaying indefinitely the recapture of OFLs and SLLs subject to SRLY.

The IRS and Treasury have decided, therefore, that the principles of SRLY are not served by applying SRLY limitations to OFL and SLL accounts of corporations joining a group. Thus, this document amends portions of §1.1502–9 to eliminate SRLY restrictions on OFL recapture. A new member’s SRLY OFL account will

March 9, 1998 24 1998–10 I.R.B.

be added to the similar consolidated OFL account of the group. For similar reasons, and to avoid an imbalance in the application of the FTC regime, the IRS and Treasury have decided that SRLY limitations should not apply to FTCs of corporations joining a group. This document also amends §1.1502–4(f) such that, in the future, there will be no SRLY limitation on the use of a member’s separate year FTCs by the group. Other limitations on the use of separate year FTCs continue to apply. See, for example, section 383.

These amendments apply to corporations becoming members of a group. They do not address the apportionment of attributes to corporations that cease to members of a group. Therefore, they only partially address the issues presented in applying the OFL and SLL rules to groups. In particular, the IRS and Treasury recognize that the retention of the notional account system of §1.1502–9 for members that cease to be members is inconsistent with the rationale for removing the SRLY limitation for FTCs and OFL accounts. The notional account system may result in a member’s taking from the group an OFL or SLL account that is unrelated to the member’s activities and future income. Accordingly, the IRS and Treasury expect in the near future to issue additional amendments to §1.1502–9. One approach under consideration would replace the notional account system with a new system that apportions accounts to a departing member based on the member’s share of group assets that would produce income subject to recapture.

Effective Date

The temporary amendments are applicable to consolidated return years beginning on or after January 1, 1997.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It is hereby certified that these regulations do not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that these regulations principally affect persons filing consolidated federal income tax returns that have carryover or carryback of credits from sepa

rate return limitation years. Available data indicates that many consolidated return filers are large companies (not small businesses). In addition, the data indicates that an insubstantial number of consolidated return filers that are smaller companies have credit carryovers or carrybacks, and thus even fewer of these filers have credit carryovers or carrybacks that are subject to the separate return limitation year rules. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking accompanying these regulations is being sent to the Small Business Administration for comment on their impact on small businesses.

Drafting Information

The principal author of these regulations is Roy A. Hirschhorn of the Office of Assistant Chief Counsel (Corporate). Other personnel from the IRS and Treasury participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding entries in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.1502–3T also issued under 26 U.S.C. 1502. Section 1.1502–9T also issued under 26 U.S.C. 1502. * * * Section 1. 1502–55T also issued under 26 U.S.C. 1502. * * * Par. 2. Section 1.1502–3 is amended by adding paragraphs (c)(3) and (e)(3) and by designating the text following the heading of paragraph (d) as paragraph (d)(l) and adding paragraph (d)(2) to read as follows:

§1.1502–3 Consolidated investment credit.

graph (c) applies to consolidated return years beginning before January 1, 1997. See §1.1502–3T(c) for the rule that limits the group’s use of a section 38 credit carryover or carryback from a SRLY for a consolidated return year beginning on or after January 1, 1997. For taxable years not subject to §1.1502–3T(c), prior law applies. See §1.1502–3 (c) in effect prior to January 12, 1998, (§1.1502–3(c) as contained in the 26 CFR part 1 edition revised April 1, 1997) for prior law.

(d) Examples. (1) * * * (2) Examples (2) and (3) of this paragraph (d) do not apply to consolidated return years beginning on or after January 1, 1997. For consolidated return years beginning on or after January 1, 1997, see §1.1502–3T(d) .

(e) * * * (3) Special effective date. This paragraph (e) applies to a consolidated return change of ownership that occurred before January 1, 1997.

Par. 3. Section 1.1502–3T is added to read as follows:

§1.1502–3T Consolidated investment credit (temporary).

(a) and (b) [Reserved]. For further guidance, see §1.15023(a) and (b).

(c) Limitation on tax credit carryovers and carrybacks from separate return limi- tation years —(1) General rule. The aggregate of a member’s unused section 38 credits arising in SRLYs that are included in the consolidated section 38 credits for all consolidated return years of the group may not exceed—

(i) The aggregate for all consolidated return years of the member’s contributions to the consolidated section 38(c) limitation for each consolidated return year; reduced by

(ii) The aggregate of the member’s section 38 credits arising and absorbed in all consolidated return years (whether or not absorbed by the member).

(2) Computational rules —(i) Mem- ber’s contribution to the consolidated section 38(c) limitation. If the consolidated section 38(c) limitation for a consolidated return year is determined by reference to the consolidated tentative minimum tax (see section 38(c)(1)(A)), then a member’s contribution to the con

1998–10 I.R.B. 25 March 9, 1998

solidated section 38(c) limitation for such year equals the member’s share of the consolidated net income tax minus the member’s share of the consolidated tentative minimum tax. If the consolidated section 38(c) limitation for a consolidated return year is determined by reference to the consolidated net regular tax liability (see section 38(c)(1)(B)), then a member’s contribution to the consolidated section 38(c) limitation for such year equals the member’s share of the consolidated net income tax minus 25 percent of the quantity which is equal to so much of the member’s share of the consolidated net regular tax liability less its portion of the $25,000 amount specified in section 38(c)(1)(B). The group computes the member~s shares by applying to the respective consolidated amounts the principles of section 1552 and the percentage method under §1.1502–33(d)(3), assuming a 100% allocation of any decreased tax liability. The group must make proper adjustments so that taxes and credits not taken into ac

count in computing the limitation under section 38(c) are not taken into account in computing the member’s share of the consolidated net income tax, etc. (See, for example, the taxes described in section 26(b) that are disregarded in computing regular tax liability.) Also, the group may apportion all or a part of the $25,000 amount (or lesser amount if reduced by section 38(c)(3)) for any year to one or more members.

(ii) Years included in computation. For purposes of computing the limitation under this paragraph (c), the consolidated return years of the group include only those years, including the year to which a credit is carried, that the member has been continuously included in the group’s consolidated return, but exclude—

(A) For carryovers, any years ending after the year to which the credit is carried; and

(B) For carrybacks, any years ending after the year in which the credit arose.

(iii) Subgroups and successors. The SRLY subgroup principles under

§1.1502–21T(c)(2) apply for purposes of this paragraph (c). The predecessor and successor principles under §1.1502– 21T(f) also apply for purposes of this paragraph (c).

(3) Effective date. This paragraph (c) applies to consolidated return years beginning on or after January 1, 1997. However, a group does not take into account a consolidated taxable year beginning before January 1, 1997, in determining a member’s (or subgroup’s) contributions to the consolidated section 38(c) limitation under this paragraph (c). See also §1.1502–3 (c) .

(d) Example. (1) The following example illustrates the provisions of paragraph (c) of this section:

Example. (i) P, the common parent of the P group, acquires all the stock of T at the beginning of Year 2. T carries over an unused section 38 general business credit from Year 1 of $100,000. The table below shows the group’s net consolidated income tax, consolidated tentative minimum tax, and consolidated net regular tax liabilities, and T’s share of such taxes computed under the principles of sectyon

Year 2	Group	P’s share of col. 1	T’s share of col. 1
1. consolidated taxable income	$2,000	$1,200	$800
2. consolidated net regular tax	$700	$420	$280
3. consolidated alternative minimum taxable income	$4,000	$3,200	$800
4. consolidated tentative minimum tax	$800	$640	$160
5. consolidated net income tax	$800	$520	$280
6. greater of line 4 or 25% of (line 2 minus $25,000)for the group	$800
7. consolidated §38(c) limitation (line 5 minus line 6)	$0

1552 and the percentage method under §1.1502–33 (d) (3), assuming a 100% allocation of any decreased tax liability, for Year 2. (The effects of the lower section 11 brackets are ignored, there are no other tax credits affecting a group amount or member’s share, and $1, 000s are omitted.)

(ii) The amount of T’s unused section 38 credits from Year 1 that are included in the consolidted section 38 credits for Year 2 may not exceed T’s contributifn to the consolidated section 38(c) limitation. For Year 2, the group determines the consolidated section 38(c) km: tation by reference to consolidated

tentative minimum tax for Year 2. Therefore, T’s contribution to the consolidated section 38(c) limitation for Year 2 equals its share of consolidated net income tax minus its share of consolidated tentativi minimum tax. T’s contribution is $280,000 minus $160,000, or $120,000. However, because the group

Year 3	Group	P’s share of col. 1	T’s share of col. 1
1. consolidated taxable income	$1,200	$1,500	$(300)
2. consolidated net regular tax	$420	$525	$(105)
3. consolidated alternative minimum taxable income	$1,500	$1,700	$(200)
4. consolidated tentative minimum tax	$300	$340	$(40)
5. consolidated net income tax	$420	$525	$(105)
6. greater of line 4 or 25% of (line 2 minus $25,000)for the group	$300
7. consolidated §38(c) limitation (line 5 minus line 6)	$120

March 9, 1998 26 1998–10 I.R.B.

consolidated return year beginning on or after January 1, 1997, as a corporation joining the group on such first day. An overall foreign loss that is part of a net operating loss or net capital loss carryover from a separate return limitation year of a member that is absorbed in a consolidated return year beginning on or after January 1, 1997, shall be added to the appropriate consolidated overall foreign loss account in the year that it is absorbed. For consolidated return years beginning on or after January 1, 1997, similar principles apply to overall foreign losses when there has been a consolidated return change of ownership (regardless of when the change of ownership occurred).

(b)(2) through (f) [Reserved]. For further guidance, see §1.1502–9(b)(2) through (f).

Par. 8. In §1.1502–21T, paragraph (c) (1) (iii) is amended by adding Example 5 to read as follows:

§1.1502–21T Net operating losses (temporary).

Example 5. Dual SRLY registers and accounting for SRLY losses actually absorbed. (i) In Year 1, T sustains a $100 net operating loss and a $50 net capital loss. At the beginning of Year 2, T becomes a member of the P group. Both of T’s carryovers from Year 1 are subject to SRLY limits under this paragraph (c) and §1.1502–22T(c). The members of the P group contribute the following to the consolidated taxable income for Years 2 and 3 (computed without regard to T’s CNOL deduction under §1.1502–21T or net capital loss carryover under §1.1502–22T):

		P	T
Year 1 (SRLY)	ordinary		(100)
Year 1 (SRLY)	capital		(50)
Year 2	ordinary	30	60
Year 2	capital	0	(20)
Year 2	ordinary	10	40
Year 3	capital	0	30

(ii) For Year 2, the group computes separate SRLY limits for each of T’s SRLY carryovers from Year 1. Under normal Internal Revenue Code rules, it determines its ability to use its capital loss carryover before it determines its ability to use its ordinary loss carryover. Under section 1211, because the group has no Year 2 capital gain, it cannot absorb any capital losses in Year 2. T’s Year 1 net capital loss and the

has a consolidated section 38 limitation of zero, it may not include any of T’s unused section 38 credits in the consolidated section 38 credits for Year 2.

(iii) The following table shows similar information for the group for Year 3:

(iv) The amount of T’s unused section 38 credits from Year 1 that are included in the consolidated section 38 credits for Year 3 may not exceed T’s aggregate contribution to the consolidated section 38(c) limitation for Years 2 and 3. For Year 3, the group determines the consolidated section 38(c) limitation by reference to the consolidated tentative minimum tax for Year 3. Therefore, T’s contribution to the consolidated section 38(c) limitation for Year 3 equals its share of consolidated net income tax minus its share of consolidated tentative minimum tax. Applying the principles of section 1552 and §l.1502–33(d) (taking into account, for example, that T’s positive earnings and profits adjustment under §1.1502–33(d) reflects its losses actually absorbed by the group), T’s contribution is $(105,000) minus $(40,000), or $(65,000). T’s /acgregate contributions to the consolidated section 38(c) l~hitation for Years 2 and 3 is $120,000 + $(65,000), or $55,000. The group may include $55,000 of T’s Year 1 unused sectio 38 credits in its consolidated section 38 tax credit in Year 3.

(2) This paragraph (d) applies to consolidated return years beginning on or after January 1, 1997. See also §1.1502– 3(d) for years prior to January 1, 1997. (e) and (f) [Reserved]. For further guidance, see §1.1502–3(e) and (f).

Par. 4. Section 1.1502–4 is amended by adding new paragraphs (f) (3) and (g) (3) to read as follows:

§1.1502–4 Consolidated foreign tax credit.

(f) * * * (3) Special effective date ending SRLY limitation. See §1.1502–4T(f) for the rule that ends the SRLY limitation with respect to foreign tax credits for consolidated return years beginning on or after January 1, 1997.

(g) * * * (3) Special effective date for CRCO limitation. See §1.1502–4T(g)(3) for the rule that ends the CRCO limitation with respect to a consolidated return change of ownership that occurred on or after January 1, 1997.

Par. 5. Section 1.1502–4T is added to read as follows:

§1.1502–4T Consolidated foreiqn tax credit (temporary).

(a) through (e) [Reserved]. For further guidance, see §1.1502–4 (a) through (e).

(f) Limitation on unused foreian tax carryover or carryback from separate re- turn limitation years. Section 1.1502–4(f) does not apply to consolidated return years beginning on or after January 1, 1997. For consolidated return years beginning on or after January 1, 1997, a group shall include an unused foreign tax of a member arising in a SRLY without regard to the contribution of the member to consolidated tax liability for the consolidated return year.

(g)(1) and (2) [Reserved]. For further guidance, see §1.1502–4 (g) (1) and (2).

(g)(3) S pecial effective date for CRCO limitation. Section 1.1502–4(g) applies to a consolidated return change of ownership that occurred before January 1, 1997.

Par. 6. In §1.1502–9, paragraph (a) is amended by adding a sentence at the end of the paragraph to read as follows:

§1.1502–9 Application of overall foreiqn loss recapture rules to corporations filing consolidated returns.

(a) In general. *** See §1.1502– 9T(b)(1)(v) for the rule that ends the separate return limitation year limitation for consolidated return years beginning on or after January 1, 1997.

Par. 7. Section 1.1502–9T is added to read as follows:

§1.1502–9T Application of overall foreign loss recapture rules to corporations filing consolidated returns (temporary).

(a) and (b) introductory text through (b)(1)(iv) [Reserved]. For further guidance, see §1.1502–9 (a) and (b) introductory text through (b) (1) (iv).

(b)(1)(v) Special effective date for SRLY limitation. Sections 1.1502–9(b)(1)(iii) and (iv) apply only to consolidated return years beginning before January 1, 1997. For consolidated return years beginning on or after January 1, 1997, the rules of §1.1502–9(b)(1)(ii) shall apply to overall foreign losses from separate return years that are separate return limitation years. For purposes of applying §1.1502–9(b)(1)(ii) in such years, the group treats a member with a balance in an overall foreign loss account from a separate return limitation year on the first day of the first

1998–10 I.R.B. 27 March 9, 1998

group’s Year 2 consolidated net capital loss fall of which is attributable to T) are carried over to Year 3.

(iii) Under this section, the aggregate amount of T’s $100 NOL carryover from Year 1 that may be included in the CNOL deduction of the group for Year 2 may not exceed $60—the amount of the consolidated taxable income computed by reference only to T’s items, including losses and deductions to the extent actually absorbed (i.e., $60 of ordinary income for Year 2). Thus, the group may include $60 of T’s ordinary loss carryover from Year 1 in its Year 2 CNOL deduction. T carries over its remaining $40 of its Year 1 loss to Year 3. (iv) For Year 3, the group again computes separate SRLY limits for each of T’s SRLY carryovers from Year 1. The group has consolidated net capital gain (without taking into account a net capital loss carryover deduction) of $30. Under 1.150222T(c), the aggregate amount of T’s $50 capital loss carryover from Year 1 that may be included in computing the group’s consolidated net capital gain for all years of the group (here Years 2 and 3) may not exceed $30 (the aggregate consolidated net capital gain computed by reference only to T’s items, including losses and deductions actually absorbed (i.e., $30 of capital gain in Year 3)). Thus, the group may include $30 of T’s Year 1 capital loss carryover in its computation of consolidated net capital gain for Year 3, which offsets the group’s capital gains for Year 3. T carries over its remaining $20 of its Year 1 loss to Year 4. The group carries over the Year 2 consolidated net capital loss to Year 4.

(v) Under this section, the aggregate amount of T’s NOL carryover from Year 1 that may be included in the CNOL deduction of the group for Years 2 and 3 may not exceed $100, which is the amount of the aggregate consolidated taxable income for Years 2 and 3 determined by reference only to T’s items, including losses and deductions actually absorbed (i.e., $60 of ordinary income in Year 2 plus $40 of ordinary income, $30 of capital gain, and $30 of SRLY capital losses actually absorbed in Year 3). The group included $60 of T’s ordinary loss carryover in its Year 2 CNOL deduction. It may include the remaining $40 of the carryover in its Year 3 CNOL deduction.

Par. 9. In §1.1502–23T, paragraphs (b) and (c) are redesignated as paragraphs (c) and (d), and a new paragraph (b) is added to read as follows:

§1.1502–23T Consolidated net section 1231 qain or loss (temporary).

(b) Example. The following example illustrates the provisions of this section:

Example. Use of SRLY registers with net gains and net losses under section 1231. (i) In Year 1, T sustains a $20 net capital loss. At the beginning of Year 2, T becomes a member of the P group. T’s capital loss carryover from Year 1 is subject to SRLY limits under §1.1502–22T(c). The members of the P group contribute the following to the consolidated taxable income for Year 2 (computed without regard to T’s net capital loss carryover under §1.1502– 22T):

		P	T
Year 1 (SRLY)	ordinary
Year 1 (SRLY)	capital		(20)
Year 2	ordinary	10	20
Year 2	capital	70	0
Year 2	§1231	(60)	30

(ii) Under section 1231, if the section 1231 losses for any taxable year exceed the section 1231 gains for such taxable year, such gains and losses are treated as ordinary gains or losses. Because the P group’s section 1231 losses, $(60), exceed the section 1231 gains, $30, the P group’s net loss is treated as ordinary loss. T’s net section 1231 gain has the same character as the P group’s consolidated net section 1231 loss, so T’s $30 of section 1231 income is treated as ordinary income for purposes applying §1.1502–22T(c). under §1.1502–22T(c), the group’s consolidated net capital gain determined by reference only to T’s items is $0. None of T’s capital loss carryover from Year 1 may be taken into account in Year 2.

Par. 10. Section 1.1502–55T is added under the undesignated center heading “Special Taxes and Taxpayers” to read as follows:

§1.1502–55T Computation of alternative minimum tax of consolidated groups (temporary).

(a) through (h)(3) [Reserved]. (h)(4) Separate return year minimum tax credit.

(i) and (ii) [Reserved]. (iii)(A) Limitation on portion of sepa- rate return year minimum tax credit aris- inq in separate return limitation years. The aggregate of a member’s minimum tax credits arising in SRLYs that are included in the consolidated minimum tax credits for all consolidated return years of the group may not exceed—

( 1 ) The aggregate for all consolidated return years of the member’s contributions to the consolidated section 53(c) limitation for each consolidated return year; reduced by

( 2 ) The aggregate of the member’s minimum tax credits arising and absorbed in all consolidated return years (whether or not absorbed by the member).

(B) Computational rules —( 1 ) Mem- ber’s contribution to the consolidated sec- tion 53(c) limitation. Except as provided in the special rule of paragraph (h)(4)(iii)(B)( 2 ) of this section, a member’s contribution to the consolidated section 53(c)

limitation for a consolidated return year equals the member’s share of the consolidated net regular tax liability minus its share of consolidated tentative minimum tax. The group computes the member’s shares by applying to the respective consolidated amounts the principles of section 1552 and the percentage method under §1.1502–33(d)(3), assuming a 100% allocation of any decreased tax liability. The group makes proper adjustments so that taxes and credits not taken into account in computing the limitation under section 53(c) are not taken into account in computing the member’s share of the consolidated net regular tax, etc. (See, for example, the taxes described in section 26(b) that are disregarded in computing regular tax liability.)

( 2 ) Adjustment for Year in which alter- native minimum tax is paid. For a consolidated return year for which consolidated tentative minimum tax is greater than consolidated regular tax liability, the group reduces the member’s share of the consolidated tentative minimum tax by the member’s share of the consolidated alternative minimum tax for the year. The group determines the member’s share of consolidated alternative minimum tax for a year using the same method it uses to determine the member’s share of the consolidated minimum tax credits for the year.

( 3 ) Years included in computation. For purposes of computing the limitation under this paragraph (h)(4)(iii), the consolidated return years of the group include only those years, including the year to which a credit is carried, that the member has been continuously included in the group’s consolidated return, but exclude any years after the year to which the credit is carried.

( 4 ) Subgroup principles. The SRLY subgroup principles under §1.1502– 21T(c)(2) apply for purposes of this paragraph (h)(4)(iii). The predecessor and successor principles under §1.1502– 21T(f) also apply for purposes of this paragraph (h) (4) (iii).

(C) Effective date. This paragraph (h)(4)(iii) applies to consolidated return years beginning on or after January 1, 1997. However, a group does not take into account a consolidated taxable year beginning before January 1, 1997, in determining a member’s (or subgroup’s) contributions to the consolidated section

March 9, 1998 28 1998–10 I.R.B.

53(c) limitation under paragraph (h)(4)(iii) of this section.

Michael P. Dolan, Deputy Commissioner of

Internal Revenue.

Approved December 11, 1997.

Donald C. Lubick, Acting Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on January 9, 1998, 8:45 a.m., and published in the issue of the Federal Register for January 12, 1998, 63 F.R. 1740)

Section 7520.—Valuation Tables

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

Section 7872.—Treatment of Loans With Below-Market Interest Rates

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of March 1998. See Rev. Rul. 98–11, page 13.

1998–10 I.R.B. 29 March 9, 1998