Part I. Rulings — Internal Revenue Bulletin 1998-15

Section 25.—Interest on Certain Home Mortgages

26 CFR 1.25–4T: Qualified mortgage credit certificate program (temporary).

Guidance is provided for the use of the national and area median gross income figures by issuers of qualified mortgage bonds and mortgage credit certificates in determining the housing cost/income ratio described in section 143(f)(5) of the Code. See Rev. Proc. 98–28, page 14.

Section 61.—Gross Income Defined

26 CFR 1.61–1: Gross income.

Relocation payments; Housing and Community Development Act. A relocation payment, authorized by section 105(a)(11) of the Housing and Community Development Act and funded under the 1997 Emergency Supplemental Appropriations Act for Recovery From Natural Disasters, made by a local jurisdiction to an individual moving from a flood-damaged residence to another residence, is not includible in the individual’s gross income.

Rev. Rul. 98–19

ISSUE

Is a relocation payment authorized pursuant to section 105(a)(11) of Title I of the Housing and Community Development Act of 1974 (Act), 42 U.S.C. § 5305(a)(11), funded under the 1997 Emergency Supplemental Appropriations Act for Recovery From Natural Disasters (Supplemental Act), Pub. L. No. 105–18, 111 Stat. 158, 198–199, and made by a local jurisdiction to an individual moving from a flood-damaged residence to another residence, includible in the individual’s gross income under § 61 of the Internal Revenue Code?

FACTS

Pursuant to the Act and the Supplemental Act, a resident of a local jurisdiction, within a Presidentially-declared disaster area in the upper Midwest, received a relocation payment from the local jurisdiction to help defray the expenses of mov

ing from the resident’s flood-damaged residence to another residence.

According to section 101(c) of the Act, the primary objective of Title I “is the development of viable urban communities, by providing decent housing and a suitable living environment and expanding economic opportunities, principally for persons of low and moderate income.” 42 U.S.C. § 5301(c). Section 105(a)(11) of the Act provides, in part, that a community development program may provide relocation payments and assistance for displaced individuals and families as authorized under the Act. 42 U.S.C. § 5305(a)(11).

The Supplemental Act provides funding, for displaced individuals and families as authorized under the Act, to certain communities affected by the flooding in the upper Midwest and other Presidentially-declared disasters occurring during the federal government’s fiscal year ending September 30, 1997.

LAW AND ANALYSIS

Section 61 and the Income Tax Regulations thereunder provide that, except as otherwise provided by law, gross income means all income from whatever source derived.

The Service has held that payments made under legislatively provided social benefit programs for the promotion of general welfare are not includible in a recipient’s gross income. See Rev. Rul. 76–373, 1976–2 C.B. 16, which holds that relocation payments received by individuals pursuant to section 105(a)(11) of the Act are in the nature of general welfare and are not includible in the gross incomes of recipients.

HOLDING

A relocation payment authorized pursuant to section 105(a)(11) of the Act, funded under the Supplemental Act, and made by a local jurisdiction to an individual moving from a flood-damaged residence to another residence, is in the nature of general welfare and is not includible in the individual’s gross income under § 61.

DRAFTING INFORMATION

The principal author of this revenue ruling is Sheldon A. Iskow of the Office

of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Iskow on (202) 622-4920 (not a toll-free call).

Section 103.—State and Local Bonds

26 CFR 1.103–1: Interest upon obligations of a State, Territory, etc.

Section 143.—Mortgage Revenue Bonds: Qualified Mortgage Bond and Qualified Veterans’ Mortgage Bond

26 CFR 6a.103A–2: Qualified mortgage bond.

Section 166.—Bad Debts

26 CFR 1.166–3: Partial or total worthlessness.

T.D. 8763

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Modifications of Bad Debts and Dealer Assignments of Notional Principal Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains regulations that deem a charge-off and allow a deduction for a partially worthless debt when the terms of a debt instrument

1998–15 I.R.B. 5 April 13, 1998

ted by the terms of the contract, the assignment is not treated as a deemed exchange by the nonassigning party of the original contract for a new contract that differs materially either in kind or in extent. Thus, an assignment to which the rule applies does not trigger gain or loss to the dealer’s counterparty.

Three comments were received on the §1.166–3T regulations. The first comment requests a deemed charge-off for a taxpayer that purchased at a discount debt for which a previous deduction for partial worthlessness was claimed, and then significantly modified the debt under §1.1001–3 and recognized gain on the modification. Whenever debt is purchased for less than the stated redemption price, recognized gain from a significant modification is attributable to market discount as defined in section 1278(a)(2)(A) and not to a previously claimed deduction for partial worthlessness. In addition, the temporary regulations refer to §1.166– 3(a)(1) and (2) for guidance relating to prior charge-offs and deductions for partial worthlessness. Extending the temporary regulations to cover a discount purchase would significantly expand the regulations beyond their intended scope and create a situation that would be extremely difficult to administer. The regulations do not adopt the request to extend the regulations to cover such a purchase.

The second comment requests a deemed charge-off for a member of a consolidated group that purchased debt, for which a previous deduction for partial worthlessness was claimed, from another member of the group, then significantly modified the debt under §1.1001–3 and recognized gain on the modification. Whenever debt is purchased for less than the stated redemption price, subsequently recognized gain from a significant modification is attributable to market discount as defined in section 1278(a)(2)(A) and not to a previously claimed deduction for partial worthlessness. Extending the temporary regulations to cover a purchase from another member of the consolidated group would significantly expand the regulations beyond their intended scope. The regulations do not adopt the request to extend the regulations to cover an intercompany transaction.

The third comment requests expanding the temporary regulations to include other

have been modified. The regulations provide guidance to certain taxpayers that have claimed a deduction for a partially worthless debt and then modified the terms of the debt instrument. This document also contains regulations relating to certain assignments of notional principal contracts by dealers in those contracts. The regulations provide guidance to taxpayers relating to the consequences of these assignments.

DATES: Effective date: These regulations are effective January 29, 1998.

Applicability date: These regulations apply to significant modifications of debt instruments and assignments of interest rate swaps, commodity swaps, and other notional principal contracts occurring on or after September 23, 1996.

FOR FURTHER INFORMATION CONTACT: Concerning the modifications of bad debts, Craig Wojay, (202) 622-3920, and concerning dealer assignments of notional principal contracts, Thomas M. Preston, (202) 622-3940 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

On June 25, 1996, temporary regulations (T.D. 8676 [1996–2 C.B. 9]) relating to modifications of bad debts and dealer assignments of notional principal contracts under sections 166 and 1001 of the Internal Revenue Code (Code) were published in the Federal Register (61 F.R. 32653). A notice of proposed rulemaking (REG–209743–94, formerly FI–59–94

[1996–2 C.B. 442]) cross-referencing the temporary regulations was published in the Federal Register for the same day (61 F.R. 32728). No public hearing was requested or held.

Written comments responding to the notice were received. After consideration of the comments, the regulations proposed by REG–209743–94 are adopted by this Treasury decision, and the corresponding temporary regulations are removed.

Explanation of Provisions

The preamble to the temporary regulations sets forth limited circumstances under which a taxpayer will be permitted

to deduct an amount on account of a partially worthless debt even though an amount has not been charged off within the taxable year.

Section 166(a)(2) and §1.166–3(a) provide that a deduction for a partially worthless debt is allowed only to the extent the debt is charged off in the taxable year. The charge-off requirement is satisfied when a portion of the debt is removed from the taxpayer’s books and records. This generally is accomplished by reducing the debt’s book basis. Thus, when an amount has been deducted for partial worthlessness, there is generally a reduction of both the book basis and the tax basis of a debt.

When a taxpayer is required to recognize gain under §1.1001–1 because of a modification of a debt instrument, the taxpayer’s tax basis in the debt is increased by the amount of gain recognized. However, regulatory and general accounting principles generally would not permit a corresponding increase in the book basis of the debt. Because the prior charge-off is not restored (that is, the book basis of the debt is not increased), there is no opportunity for the taxpayer to take a new charge-off for pre-existing worthlessness.

The purpose of the temporary regulations is to preserve a portion of a taxpayer’s bad debt deduction with respect to a partially worthless debt. The portion preserved corresponds to the amount the taxpayer would have been entitled to deduct for partial worthlessness with respect to the modified debt if the book basis of the modified debt were increased to the same extent as the tax basis of that debt. Thus, if all the conditions of the temporary regulations are satisfied, then a modified debt is deemed to have been charged off in the year in which gain is recognized. The amount of the deemed charge-off, however, is limited to the difference between the tax basis of the debt and the greater of the book basis or the fair market value of the debt. The temporary regulations also address debt that constitutes transferred basis property under section 7701(a)(43).

In addition, the temporary regulations provide a limited rule dealing with a dealer’s assignment of its position in an interest rate swap, commodity swap, or other notional principal contract to another dealer. If the assignment is permit

April 13, 1998 6 1998–15 I.R.B.

party on an interest rate or commodity swap, or other notional principal contract (as defined in §1.446–3(c)(1)), is not treated as a deemed exchange by the nonassigning party of the original contract for a modified contract that differs materially either in kind or in extent if—

(1) The party assigning its rights and obligations under the contract and the party to which the rights and obligations are assigned are both dealers in notional principal contracts, as defined in §1.446–3(c)(4)(iii); and

(2) The terms of the contract permit the substitution.

(b) Effective date. This section applies to assignments of interest rate swaps, commodity swaps, and other notional principal contracts occurring on or after September 23, 1996.

§1.1001–4T [Removed]

Par. 5. Section 1.1001–4T is removed.

Michael P. Dolan, Deputy Commissioner of

Internal Revenue.

Approved January 14, 1998.

Donald C. Lubick, Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on January 28, 1998, 8:45 a.m., and published in the issue of the Federal Register for January 29, 1998, 63 F.R. 4396)

Section 471.—General Rule for Inventories

26 CFR 1.471–2: Valuation of inventories.

Guidance, including a “retail safe harbor method,” is provided for a taxpayer that wants to change to a method of accounting for estimating inventory “shrinkage” in computing ending inventory. See Rev. Proc. 98–29, page 22.

Section 472.—Last-in, First-out Inventories

26 CFR 1.472–1: Last-in, first-out inventories.

LIFO; price indexes; department stores. The February 1998 Bureau of Labor Statistics price indexes are accepted for use by department stores em

situations in which a taxpayer has tax basis in a debt but no corresponding book basis. The first situation involves the accrual of interest income on loans that have been placed on non-accrual status for book purposes. The second situation involves the requirement to accrue interest on original issue discount obligations even if the loan has become uncollectible. This comment deals with situations other than the modification of a debt instrument and is beyond the scope of this regulation project.

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 regulation does 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, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of the regulations concerning the modifications of bad debts is Craig Wojay, Office of the Assistant Chief Counsel (Financial Institutions and Products), IRS. The principal author of the regulations concerning the dealer assignments of notional principal contracts is Thomas M. Preston, Office of the Assistant Chief Counsel (Financial Institutions and Products), IRS. However, other personnel from the IRS and Treasury Department 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 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. In §1.166–3, paragraph (a)(3) is added to read as follows:

§1.166–3 Partial or total worthlessness.

(a) * * * (3) Significantly modified debt —(i) Deemed charge-off. If a significant modification of a debt instrument (within the meaning of §1.1001–3) during a taxable year results in the recognition of gain by a taxpayer under §1.1001–1(a), and if the requirements of paragraph (a)(3)(ii) of this section are met, there is a deemed charge-off of the debt during that taxable year in the amount specified in paragraph (a)(3)(iii) of this section.

(ii) Requirements for deemed charge- off. A debt is deemed to have been charged off only if—

(A) The taxpayer (or, in the case of a debt that constitutes transferred basis property within the meaning of section 7701(a)(43), a transferor taxpayer) has claimed a deduction for partial worthlessness of the debt in any prior taxable year; and

(B) Each prior charge-off and deduction for partial worthlessness satisfied the requirements of paragraphs (a)(1) and (2) of this section.

(iii) Amount of deemed charge-off. The amount of the deemed charge-off, if any, is the amount by which the tax basis of the debt exceeds the greater of the fair market value of the debt or the amount of the debt recorded on the taxpayer’s books and records reduced as appropriate for a specific allowance for loan losses. The amount of the deemed charge-off, however, may not exceed the amount of recognized gain described in paragraph (a)(3)(i) of this section.

(iv) Effective date. This paragraph (a)(3) applies to significant modifications of debt instruments occurring on or after September 23, 1996.

§1.166–3T [Removed]

Par. 3. Section 1.166–3T is removed. Par. 4. Section 1.1001–4 is added to read as follows:

§1.1001–4 Modifications of certain notional principal contracts.

(a) Dealer assignments. For purposes of §1.1001–1(a), the substitution of a new

1998–15 I.R.B. 7 April 13, 1998

ploying the retail inventory and last-in, first-out inventory methods for valuing inventories for tax years ended on, or with reference to, February 28, 1998.

Rev. Rul. 98–20

The following Department Store Inventory Price Indexes for February 1998 were issued by the Bureau of Labor Sta

tistics. The indexes are accepted by the Internal Revenue Service, under § 1.472– 1(k) of the Income Tax Regulations and Rev. Proc. 86–46, 1986–2 C.B. 739, for appropriate application to inventories of department stores employing the retail inventory and last-in, first-out inventory methods for tax years ended on, or with reference to, February 28, 1998.

The Department Store Inventory Price

Indexes are prepared on a national basis and include (a) 23 major groups of departments, (b) three special combinations of the major groups - soft goods, durable goods, and miscellaneous goods, and (c) a store total, which covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco, and contract departments.

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS

(January 1941 = 100, unless otherwise noted)

Percent Change Groups Feb. Feb. from Feb. 1997 1997 1998 to Feb. 1998 ¹

Piece Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526.4 535.8 1.8
Domestics and Draperies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 650.4 639.3 –1.7
Women’s and Children’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640.2 656.9 2.6
Men’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 897.7 886.5 –1.2
Infants’ Wear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617.7 612.6 –0.8
Women’s Underwear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534.2 565.2 5.8
Women’s Hosiery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296.5 308.1 3.9
Women’s and Girls’Accessories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546.9 548.2 0.2
Women’s Outerwear and Girls’ Wear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417.6 408.9 –2.1
Men’s Clothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615.4 624.0 1.4
Men’s Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585.1 590.4 0.9
Boys’ Clothing and Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469.9 499.3 6.3
Jewelry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1004.9 1001.0 –0.4
Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 772.0 802.0 3.9
Toilet Articles and Drugs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 912.3 926.5 1.6
Furniture and Bedding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 662.0 668.3 1.0
Floor Coverings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 581.2 583.7 0.4
Housewares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 817.0 810.3 –0.8
Major Appliances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246.1 242.0 –1.7
Radio and Television . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78.6 73.6 –6.4
Recreation and Education ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111.1 107.7 –3.1
Home Improvements ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133.3 134.0 0.5
Auto Accessories ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107.9 107.7 –0.2 Groups 1 – 15: Soft Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 598.9 601.1 0.4 Groups 16 – 20: Durable Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470.0 462.4 –1.6 Groups 21 – 23: Misc. Goods ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113.3 111.0 –2.0 Store Total ³ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 554.2 552.3 –0.3

1Absence of a minus sign before percentage change in this column signifies price increase. 2Indexes on a January 1986=100 base. 3The store total index covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco, and contract departments.

April 13, 1998 8 1998–15 I.R.B.

A. Current temporary regulations and

TRA 97. Section 927(e)(1) provides that “[u]nder regulations, the income of a person described in section 482 from a transaction giving rise to foreign trading gross receipts of a FSC which is treated as from sources outside the United States shall not exceed the amount which would be treated as foreign source income earned by such person if the pricing rule under section 994 which corresponds to the rule used under section 925 with respect to such transaction applied to such transaction.” Transactions giving rise to foreign trading gross receipts include qualifying sales, leases, licenses and services. Current §1.927(e)–1T restates the section 927(e)(1) rule as applicable on “the sale of export property.” While the statute is not limited to export sale transactions in that it applies to any transaction giving rise to foreign trading gross receipts of a FSC, the current regulation might be interpreted to apply the special foreign sourcing limit only to sales of export property.

Section 1171 of the Taxpayer Relief Act of 1997 (TRA 97) amended section 927(a)(2)(B) (without any inference intended regarding prior law) to provide

DRAFTING INFORMATION

The principal author of this revenue ruling is Stan Michaels of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Michaels on (202) 622-4970 (not a tollfree call).

Section 925.—Transfer Pricing Rules

26 CFR 1.925(a)–1T: Temporary regulations; transfer pricing rules for FSCs.

T.D. 8764

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Source and Grouping Rules for Foreign Sales Corporation Transfer Pricing

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains temporary regulations that provide guidance to taxpayers who have made an election to be treated as a foreign sales corporation (FSC). The regulations provide rules that clarify the special sourcing rules under section 927(e)(1) and provide a deadline for the election to group transactions. The text of the temporary regulations also serves as the text of the proposed regulations on this subject in REG– 102144–98, page 25 of this Bulletin.

DATES: Effective date: These regulations are effective March 3, 1998.

Applicability: For dates of applicability, see §§1.925(a)–1T(c)(8)(i) and 1.927(e)–1T(c).

FOR FURTHER INFORMATION CONTACT: Elizabeth Beck (202) 622-3880 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Income Tax Regulations (26 CFR part

under sections 925 and 927 which were

added by the Deficit Reduction Act of 1984, applicable for taxable years of foreign sales corporations beginning after December 31, 1984. Temporary regulations were published in the Federal Reg- ister (52 F.R. 6468) as a Treasury Decision (T.D. 8126 [1987–1 C.B. 184]) on March 3, 1987. Treasury and IRS believe that immediate guidance in the form of these temporary regulations is necessary for the reasons stated below.

Explanation of Provisions

These regulations set a deadline for an election to group transactions for purposes of the foreign sales corporation (FSC) administrative pricing methods and clarify that the foreign source limit for a FSC’s related supplier extends to all transactions giving rise to foreign trading gross receipts.

I. Grouping Election Deadline.

A. Current temporary regulations.

Current §1.925(a)–1T(c)(8) and §1.925(b)–1T(b)(3) permit taxpayers annually to group transactions in applying the administrative pricing (including the marginal costing) rules to determine FSC benefits. Current §1.925(a)–1T(c)(8)(i) requires an election to group to be evidenced on the FSC income tax return for the taxable year. Current §1.925(a)– 1T(e)(4) authorizes taxpayers to file amended returns subsequently (within the statute of limitations period) to redetermine FSC benefits based on a different grouping of transactions than that originally elected. Pursuant to this provision, taxpayers may change their grouping basis, or change from a grouping to a transaction-by-transaction basis. The IRS and the Treasury have become increasingly aware of taxpayers who, through the use of sophisticated computer programs, substantially revise their transaction groupings just prior to the expiration of the statute of limitations and many years after the original returns were filed. These revised groupings typically employ complex estimating techniques. The recent rise in this practice is placing a significant burden on the auditing process and is creating a potential for abuse.

B. Revised temporary regulations.

Under §1.925(a)–1T(c)(8)(i), the election to group must be made on Schedule P

of the FSC’s timely filed U.S. income tax return (including extensions thereof) for the taxable year. No untimely or amended returns will be allowed to elect to group, to change a grouping basis, or to change from a grouping basis to a transaction-by-transaction basis for such year.

Conforming changes and cross-references are reflected in §1.925(a)–1T(e)(4) and §1.925(b)–1T(b)(3).

The regulations apply to taxable years beginning after December 31, 1997. There is also a transition rule providing that the regulations also apply to taxable years beginning before January 1, 1998. For these taxable years, the transition rule allows taxpayers to redetermine their grouping of transactions with respect to such years provided such redetermination is made no later than the due date of the FSC’s timely filed U.S. income tax return (including extensions thereof) for its first taxable year beginning after December 31, 1997.

II. Scope of Related Supplier Foreign

Source Limit .

1998–15 I.R.B. 9 April 13, 1998

that computer software licensed for reproduction abroad is included within the definition of export property for purposes of the FSC provisions. The amendment applies to gross receipts from computer software licenses attributable to periods after December 31, 1997, in tax years ending after such date.

In light of TRA 97, it is important to clarify the scope of the related supplier’s foreign source limit under the regulations. This clarification needs to be implemented immediately in order to provide clear guidance to taxpayers, including those utilizing the TRA 97 amendment to section 927(a)(2)(B).

B. Revised temporary regulations. Under §1.927(e)–1T(a)(1), the related supplier’s foreign source limit applies to any transaction, including but not limited to any sale, lease, license or service, giving rise to foreign trading gross receipts of a FSC. No inference is intended regarding the scope of application of the prior regulation.

Conforming changes are reflected in §1.927(e)–1T(a)(2) and (3). Special rules are added in §1.927(e)–1T(a)(3)(ii) to clarify how the corresponding DISC transfer pricing rules are to be applied for purposes of the foreign source limit. Three examples set forth in §1.927(e)– 1T(b) illustrate how the limit is applied under different transfer pricing methods and for different types of transactions.

The regulations apply to taxable years beginning after December 31, 1997.

Special Analyses

It has been determined that this Treasury Decision is not a significant regulatory action as defined in Executive Order 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, and because the regulation does 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

The principal author of these regulations is Elizabeth Beck of the Office of the Associate Chief Counsel (International). Other personnel from the IRS and Treasury Department also participated in the development of 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 revising the entries for sections 1.925(a)–1T and 1.925(b)–1T to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.925(a)–1T is also issued under 26 U.S.C. 925(b)(1) and (2) and 927(d)(2)(B). Section 1.925(b)–1T is also issued under 26 U.S.C. 925(b)(1) and (2) and 927(d)(2)(B) * * * Par. 2. Section 1.925(a)–1T is amended by:

Removing the last sentence of paragraph (c)(8)(i) and adding five sentences in its place.
Paragraph (e)(4) is amended by: a. Removing the language “or grouping of transactions” from the fourth sentence.

b. Adding a sentence to the end of the paragraph.

The additions read as follows:

§1.925(a)–1T Temporary Regulations; Transfer pricing rules for FSCs.

(c) * * * (8) * * * (i) * * * The election to group transactions shall be evidenced on Schedule P of the FSC’s timely filed U.S. income tax return (including extensions thereof) for the taxable year. No untimely or amended returns will be allowed to elect to group, to change a grouping basis, or to change from a grouping basis to a transaction-by-transaction basis. The rules of the previous two sentences of this paragraph (c)(8)(i) are applicable to taxable years beginning after December 31,

For any taxable year beginning before January 1, 1998, for which a redetermination is otherwise permissible under paragraph (e)(4) of this section as in effect for taxable years beginning before January 1, 1998, a redetermination of grouping of transactions cannot be made later than the due date of the FSC’s timely filed U.S. income tax return (including extensions thereof) for the FSC’s first taxable year beginning after December 31,
The language “or grouping of transactions” is removed from the fourth sentence of paragraph (e)(4) of this section, applicable to taxable years beginning after December 31, 1997.

(e) * * * (4) * * * For the election to group transactions for purposes of applying the administrative pricing methods, see paragraph (c)(8)(i) of this section.

Par. 3. In §1.925(b)–1T, paragraph (b)(3)(i) is amended by adding at the end of the paragraph the following sentence:

§1.925(b)–1T Temporary regulations; marginal costing rules.

(b) * * * (3) * * * (i) * * * For the election to group transactions for purposes of applying the administrative pricing methods, see §1.925(a)–1T(c)(8)(i).

Par. 4. Section 1.927(e)–1T is revised to read as follows:

§1.927(e)–1T Temporary regulations; special sourcing rule.

(a) Source rules for related persons (1) In general. The income of a person described in section 482 from a transaction giving rise to foreign trading gross receipts of a FSC which is treated as from sources outside the United States shall not exceed the amount which would be treated as foreign source income earned by such person if the pricing rule under section 994 which corresponds to the rule used under section 925 with respect to such transaction applied to such transac

April 13, 1998 10 1998–15 I.R.B.

tion. This section applies to any transaction, including but not limited to any sale, lease, license or service, giving rise to foreign trading gross receipts of a FSC. This special sourcing rule also applies if the FSC is acting as a commission agent for the related supplier with respect to the transaction described above which gives rise to foreign trading gross receipts and the transfer pricing rules of section 925 are used to determine the commission payable to the FSC. No limitation results under this section with respect to a transaction to which the section 482 pricing rule under section 925(a)(3) applies.

(2) Grouping of transactions. If, for purposes of determining the FSC’s profits under the administrative pricing rules of sections 925(a)(1) and (2), grouping of transactions under §1.925(a)–1T(c)(8) was elected, the same grouping shall be used for making the determinations under this special sourcing rule.

(3) Corresponding DISC pricing rules —(i) In general. For purposes of this section—

(A) The DISC gross receipts pricing rule of section 994(a)(1) corresponds to the gross receipts pricing rule of section 925(a)(1); (B) The DISC combined taxable income pricing rule of section 994(a)(2) corresponds to the combined taxable income pricing rule of section 925(a)(2); and

(C) The DISC section 482 pricing rule of section 994(a)(3) corresponds to the section 482 pricing rule of section 925(a)(3). (ii) Special rules. For purposes of this section—

(A) The DISC pricing rules of section 994(a)(1) and (2) shall be determined without regard to export promotion expenses;

(B) Qualified export receipts under section 994(a)(1) and (2) shall be deemed to be an amount equal to the foreign trading gross receipts arising from the transaction; and

(C) Combined taxable income for purposes of section 994(a)(2) shall be deemed to be an amount equal to the combined taxable income for purposes of section 925(a)(2) arising from the transaction.

(b) Examples. The provisions of this section may be illustrated by the following examples:

Example 1. (i) R and F are calendar year taxpayers. R, a domestic manufacturing company, owns all the stock of F, which is a FSC acting as a commission agent for R. For the taxable year, R and F used the combined taxable income pricing rule of section 925(a)(2). For the taxable year, the combined taxable income of R and F is $100 from the sale of export property, as defined in section 927(a), manufactured by R using production assets located in the United States. Title to the export property passed outside of the United States.

(ii) Under section 925(a)(2), 23 percent of the $100 combined taxable income of R and F, that is $23, is allocated to F and the remaining $77 is allocated to R. Absent the special sourcing rule, under section 863(b) the $77 income allocated to R would be sourced $38.50 U.S. source and $38.50 foreign source. Under the special sourcing rule, the amount of foreign source income earned by a related supplier of a FSC shall not exceed the amount that would result if the corresponding DISC pricing rule applied. The DISC combined taxable income pricing rule of section 994(a)(2) corresponds to the combined taxable income pricing rule of section 925(a)(2). Under section 994(a)(2), $50 of the combined taxable income ($100 x .50) would be allocated to the DISC and the remaining $50 would be allocated to the related supplier. Under section 863(b), the $50 income allocated to the DISC’s related supplier would be sourced $25 U.S. source and $25 foreign source. Accordingly, under the special sourcing rule, the foreign source income of R shall not exceed $25.

Example 2. (i) Assume the same facts as in Ex- ample 1 except that the combined taxable income arises from the licensing of the copyright rights in computer software for use outside of the United States and that R developed the computer software in the United States.

(ii) Under section 925(a)(2), 23 percent of the $100 combined taxable income of R and F, that is $23, is allocated to F and the remaining $77 is allocated to R. Absent the special sourcing rule, under section 862(a)(4) the $77 income allocated to R would be sourced $77 foreign source in its entirety. Under the special sourcing rule, the amount of foreign source income earned by a related supplier of a FSC shall not exceed the amount that would result if the corresponding DISC pricing rule applied. The DISC combined taxable income pricing rule of section 994(a)(2) corresponds to the combined taxable income pricing rule of section 925(a)(2). Under section 994(a)(2), $50 of the combined taxable income ($100 x .50) would be allocated to the DISC and the remaining $50 would be allocated to the related supplier. Under section 862(a)(4), the $50 income allocated to the DISC’s related supplier would be sourced $50 foreign source in its entirety. Accordingly, under the special sourcing rule, the foreign source income of R shall not exceed $50.

Example 3. (i) Assume the same facts as in Ex- ample 1 except that R and F used the gross receipts

pricing rule of section 925(a)(1). In addition, for the taxable year foreign trading gross receipts derived from the sale of the export property are $2,000.

(ii) Under section 925(a)(1), 1.83 percent of the $2,000 foreign trading gross receipts, that is $36.60, is allocated to F and the $63.40 remaining combined taxable income ($100 - $36.60) is allocated to R. Absent the special sourcing rule, under section 863(b) the $63.40 income allocated to R would be sourced $31.70 U.S. source and $31.70 foreign source. Under the special sourcing rule, the amount of foreign source income earned by a related supplier of a FSC shall not exceed the amount that would result if the corresponding DISC pricing rule applied. The DISC gross receipts pricing rule of section 994(a)(1) corresponds to the gross receipts pricing rule of section 925(a)(1). Under section 994(a)(1), $80 ($2,000 x .04) would be allocated to the DISC and the $20 remaining combined taxable income would be allocated to the related supplier. Under section 863(b), the $20 income allocated to the DISC’s related supplier would be sourced $10 U.S. source and $10 foreign source. Accordingly, under the special sourcing rule, the foreign source income of R shall not exceed $10.

Michael P. Dolan, Deputy Commissioner of

Internal Revenue.

Approved February 20, 1998.

Donald C. Lubick, Acting Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on March 2, 1998, 8:45 a.m., and published in the issue of the Federal Register for March 3, 1998, 63 F.R. 10305)

Section 1441.—Withholding of Tax

This notice announces that the Department of the Treasury and the Internal Revenue Service will amend the effective date of the section 1441 withholding regulations to apply to payments made after December 31, 1999. The transition rules provided under those regulations will also be amended to be consistent with the later effective date of those regulations. This Notice also amends the related transition rule of Notice 97–66, 1997–48 I.R.B. 8, to be consistent with the later effective date of the 1441 regulations. Finally, this Notice announces that the Internal Revenue Service intends to develop model withholding agreements for qualified intermediaries on a country by country basis. See Notice 98–16, page 12.

1998–15 I.R.B. 11 April 13, 1998