Part I. Rulings — Internal Revenue Bulletin 1999-5

ductible business expenses under § 162(a), regardless of the distance.

Rev. Rul. 94–47, 1994–2 C.B. 18, amplifies and clarifies Rev. Rul. 190 and Rev. Rul. 90–23, and provides several rules for determining whether daily transportation expenses are deductible business expenses under § 162(a). Under Rev. Rul. 94–47, a taxpayer generally may not deduct daily transportation expenses incurred in going between the taxpayer’s residence and a work location. A taxpayer, however, may deduct daily transportation expenses incurred in going between the taxpayer’s residence and a temporary work location outside the metropolitan area where the taxpayer lives and normally works. In addition, Rev. Rul. 94–47 clarifies Rev. Rul. 90–23 to provide that a taxpayer must have at least one regular place of business located “away from the taxpayer’s residence” in order to deduct daily transportation expenses incurred in going between the taxpayer’s residence and a temporary work location in the same trade or business, regardless of the distance. In this regard, Rev. Rul. 94–47 also states that the Service will not follow the decision in Walker v. Commissioner, 101 T.C. 537 (1993). Finally, Rev. Rul. 94–47 amplifies Rev. Rul. 190 and Rev. Rul. 90–23 to provide that, if the taxpayer’s residence is the taxpayer’s principal place of business within the meaning of § 280A(c)(1)(A), the taxpayer may deduct daily transportation expenses incurred in going between the taxpayer’s residence and another work location in the same trade or business, regardless of whether the other work location is regular or temporary and regardless of the distance.

For purposes of both Rev. Rul. 90–23 and Rev. Rul. 94–47, a temporary work location is defined as any location at which the taxpayer performs services on an irregular or short-term ( i.e., generally a matter of days or weeks) basis. However, for purposes of determining whether daily transportation expense allowances and per diem travel allowances for meal and lodging expenses are subject to income tax withholding under § 3402, Rev. Rul. 59–371, 1959–2 C.B. 236, provides a 1year standard to determine whether a

Section 162.—Trade or Business Expenses

26 CFR 1.162–2: Traveling expenses. (Also sections 262; 1.262–1.)

Deductibility of daily transportation expenses. This ruling provides the rules for determining whether daily transportation expenses incurred by a taxpayer in going between the taxpayer’s residence and a work location are deductible business expenses under section 162(a) of the Code.

Rev. Rul. 99–7

ISSUE

Under what circumstances are daily transportation expenses incurred by a taxpayer in going between the taxpayer’s residence and a work location deductible under § 162(a) of the Internal Revenue Code?

LAW AND ANALYSIS

Section 162(a) allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Section 262, however, provides that no deduction is allowed for personal, living, or family expenses.

A taxpayer’s costs of commuting between the taxpayer’s residence and the taxpayer’s place of business or employment generally are nondeductible personal expenses under §§ 1.162–2(e) and 1.262–1(b)(5) of the Income Tax Regulations. However, the costs of going between one business location and another business location generally are deductible under § 162(a). Rev. Rul. 55–109, 1955–1 C.B. 261. Section 280A(c)(1)(A) (as amended by § 932 of the Taxpayer Relief Act of 1997, Pub. L. No. 105–34, 111 Stat. 881, effective for taxable years beginning after December 31, 1998) provides, in part, that a taxpayer may deduct expenses for the business use of the portion of the taxpayer’s personal residence that is exclusively used on a regular basis as the principal place of business for any trade or business of the taxpayer. (In the case of an employee, however, such expenses are

deductible only if the exclusive and regular use of the portion of the residence is for the convenience of the employer.) In Curphey v. Commissioner, 73 T.C. 766 (1980), the Tax Court held that daily transportation expenses incurred in going between an office in a taxpayer’s residence and other work locations were deductible where the home office was the taxpayer’s principal place of business within the meaning of § 280A(c)(1)(A) for the trade or business conducted by the taxpayer at those other work locations. The court stated that “[w]e see no reason why the rule that local transportation expenses incurred in travel between one business location and another are deductible should not be equally applicable where the taxpayer’s principal place of business with respect to the activities in- volved is his residence. ” 73 T.C. at 777– 778 (emphasis in original). Implicit in the court’s analysis in Curphey is that the deductibility of daily transportation expenses is determined on a business-bybusiness basis.

Rev. Rul. 190, 1953–2 C.B. 303, provides a limited exception to the general rule that the expenses of going between a taxpayer’s residence and a work location are nondeductible commuting expenses. Rev. Rul. 190 deals with a taxpayer who lives and ordinarily works in a particular metropolitan area but who is not regularly employed at any specific work location. In such a case, the general rule is that daily transportation expenses are not deductible when paid or incurred by the taxpayer in going between the taxpayer’s residence and a temporary work site in- side that metropolitan area because that area is considered the taxpayer’s regular place of business. However, Rev. Rul. 190 holds that daily transportation expenses are deductible business expenses when paid or incurred in going between the taxpayer’s residence and a temporary work site outside that metropolitan area.

Rev. Rul. 90–23, 1990–1 C.B. 28, distinguishes Rev. Rul. 190 and holds, in part, that, for a taxpayer who has one or more regular places of business, daily transportation expenses paid or incurred in going between the taxpayer’s residence and temporary work locations are de

February 1, 1999 4 1999–5 I.R.B.

work location is temporary. Similarly, for purposes of determining the deductibility of travel away-from-home expenses under § 162(a)(2), Rev. Rul. 93–86, 1993–2 C.B. 71, generally provides a 1-year standard to determine whether a work location will be treated as temporary .

The Service has reconsidered the definition of a temporary work location in Rev. Rul. 90–23 and Rev. Rul. 94–47, and will replace the “irregular or short-term ( i.e., generally a matter of days or weeks) basis” standard in those rulings with a 1year standard similar to the rules set forth in Rev. Rul. 59–371 and Rev. Rul. 93–86.

If an office in the taxpayer’s residence satisfies the principal place of business requirements of § 280A(c)(1)(A), then the residence is considered a business location for purposes of Rev. Rul. 90–23 or Rev. Rul. 94–47. In these circumstances, the daily transportation expenses incurred in going between the residence and other work locations in the same trade or business are ordinary and necessary business expenses (deductible under § 162(a)). See Curphey; see also Wisconsin Psychiatric Services v. Commissioner, 76 T.C. 839 (1981). In contrast, if an office in the taxpayer’s residence does not satisfy the principal place of business requirements of § 280A(c)(1)(A), then the business activity there (if any) is not sufficient to overcome the inherently personal nature of the residence and the daily transportation expenses incurred in going between the residence and regular work locations. In these circumstances, the residence is not considered a business location for purposes of Rev. Rul. 90–23 or Rev. Rul. 94–47, and the daily transportation expenses incurred in going between the residence and regular work locations are personal expenses (nondeductible under §§ 1.162–2(e) and 1.262–1(b)(5)). See Green v. Commissioner, 59 T.C. 456 (1972); Fryer v. Commissioner, T.C. M. 1974–77. For purposes of determining the deductibility of travel-away-from-home expenses under §162(a)(2), Rev. Rul. 93–86 defines “home” as the “taxpayer’s regular or principal (if more than one regular) place of business.” See Daly v. Commis- sioner, 72 T.C. 190 (1979), aff’d, 662 F.2d 253 (4th Cir. 1981); Flowers v. Commis- sioner, 326 U.S. 465 (1946), 1946–1 C.B. 57.

HOLDING

In general, daily transportation expenses incurred in going between a taxpayer’s residence and a work location are nondeductible commuting expenses. However, such expenses are deductible under the circumstances described in paragraph (1), (2), or (3) below.

(1) A taxpayer may deduct daily transportation expenses incurred in going between the taxpayer’s residence and a tem- porary work location outside the metropolitan area where the taxpayer lives and normally works. However, unless paragraph (2) or (3) below applies, daily transportation expenses incurred in going between the taxpayer’s residence and a temporary work location within that metropolitan area are nondeductible commuting expenses.

(2) If a taxpayer has one or more regular work locations away from the taxpayer’s residence, the taxpayer may deduct daily transportation expenses incurred in going between the taxpayer’s residence and a temporary work location in the same trade or business, regardless of the distance. (The Service will continue not to follow the Walker decision.)

(3) If a taxpayer’s residence is the taxpayer’s principal place of business within the meaning of § 280A(c)(1)(A), the taxpayer may deduct daily transportation expenses incurred in going between the residence and another work location in the same trade or business, regardless of whether the other work location is regular or temporary and regardless of the distance.

For purposes of paragraphs (1), (2), and (3), the following rules apply in determining whether a work location is temporary. If employment at a work location is realistically expected to last (and does in fact last) for 1 year or less, the employment is temporary in the absence of facts and circumstances indicating otherwise. If employment at a work location is realistically expected to last for more than 1 year or there is no realistic expectation that the employment will last for 1 year or less, the employment is not temporary, regardless of whether it actually exceeds 1 year. If employment at a work location initially is realistically expected to last for 1 year or less, but at some later date the employment is realistically expected to exceed 1

year, that employment will be treated as temporary (in the absence of facts and circumstances indicating otherwise) until the date that the taxpayer’s realistic expectation changes, and will be treated as not temporary after that date.

The determination that a taxpayer’s residence is the taxpayer’s principal place of business within the meaning of § 280A(c)(1)(A) is not necessarily determinative of whether the residence is the taxpayer’s tax home for other purposes, including the travel-away-from-home deduction under § 162(a)(2).

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 190 and Rev. Rul. 59–371 are obsoleted. Rev. Rul. 90–23 and Rev. Rul 94–47 are modified (regarding the definition of temporary work location) and superseded. With respect to issues (2) and (3) in Rev. Rul. 90–23 (regarding the gross income and employment tax treatment of reimbursements for employee daily transportation expenses), see § 1.62–2 regarding reimbursements in general, and Rev. Proc. 97-58 (particularly sections 3, 9, and 10), 1997–2 C.B. 587 (or any successor), regarding reimbursements using the optional business standard mileage rate. Rev. Rul. 93–86 is distinguished.

DRAFTING INFORMATION

The principal author of this revenue ruling is Edwin B. Cleverdon of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Cleverdon at (202) 622-4920 (not a toll-free call).

Section 195.—Start-up Expenditures

26 CFR 1.195–1: Election to amortize start-up expenditures.

T.D. 8797

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

Election to Amortize Start-Up Expenditures for Active Trades or Businesses

1999–5 I.R.B 5 February 1, 1999

cluding any extensions of time) for the taxable year in which the active trade or business begins. Thus, a taxpayer may file an election for any taxable year prior to the year in which the taxpayer’s active trade or business begins, and such election will become effective in the month of the year in which the taxpayer’s active trade or business begins.

One commentator suggested that the provision in the proposed regulations permitting the filing of a revised statement to include any start-up expenditures not included in the taxpayer’s original election statement appears to endorse the practice of those taxpayers who file elections listing token or zero start-up expenditures on the election statement and subsequently attempt to increase the amount subject to amortization by expenditures that taxpayers have been unsuccessful in maintaining as expansion costs. The provision is not designed to permit a taxpayer to revise the election statement to include start-up expenditures omitted by reason of the taxpayer’s claim on the taxpayer’s return that the expenditures are expansion costs. Accordingly, the regulations have been clarified to provide that the election statement may not be revised to include expenditures that a taxpayer has treated on the taxpayer’s tax return in a manner inconsistent with their treatment as start-up expenditures.

Another commentator suggested that a separate statement to make the election under section 195 should not be required for small businesses, but rather a checkthe-box election should be provided. A separate statement is necessary to ensure that the expenses listed therein are properly characterized as start-up expenditures, and that amortization of the start-up expenditures will begin and end at the proper times. The statement is simple to complete and the time to prepare the statement is minimal. Accordingly, the final regulations retain the requirement that a separate statement with the requisite information be attached to the taxpayer’s return.

Special Analyses

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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations concerning start-up expenditures for active trades or businesses under section 195. These regulations are necessary to provide rules and procedures for electing to amortize start-up expenditures under section 195. They affect all taxpayers wishing to amortize start-up expenditures under section 195.

DATES: Effective Date: These regulations are effective December 17, 1998.

Applicability Date: For the date of applicability of these regulations, see §1.195–1(d).

FOR FURTHER INFORMATION CONTACT: David Selig, (202) 622-3040 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

The estimated annual burden per respondent varies from .10 hours to .50 hours, depending on individual circumstances, with an estimated average of .25 hours.

Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Books or records relating to this collection of information must be retained as long as their contents may become mater

ial in the administration of any internal revenue law. generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

Section 195 was added to the Internal Revenue Code of 1954 by section 102 of the Miscellaneous Revenue Act of 1980, and was amended by section 94 of the Tax Reform Act of 1984.

Section 195 generally provides that no deduction is allowed for start-up expenditures unless the taxpayer elects to amortize the expenditures. Under section 195(b)(1), if the taxpayer elects to amortize start-up expenditures, the expenditures are amortizable over a period of not less than 60 months beginning with the month in which the active trade or business begins. Section 195(d) provides that an election to amortize start-up expenditures must be made not later than the time prescribed by law for filing the return for the taxable year in which the active trade or business begins (including extensions thereof).

On January 13, 1998, the IRS published a notice of proposed rulemaking

[REG–209373–81, 1998–14 I.R.B. 26] in the Federal Register (63 F.R. 1933) proposing amendments to the Income Tax Regulations (26 CFR part 1) concerning the election to amortize start-up expenditures under section 195 of the Internal Revenue Code. A public hearing was scheduled for June 2, 1998, pursuant to a notice of public hearing published simultaneously with the notice of proposed rulemaking. No one requested to speak at the public hearing, therefore, no public hearing was held. Written comments responding to the notice were received. After consideration of all of the comments, the proposed regulations are adopted as revised by this Treasury decision.

Explanation of Revisions and Discussion of Comments

The proposed regulations provide that an election to amortize start-up expenditures is made by attaching a statement to the taxpayer’s income tax return. The income tax return and statement must be filed not later than the date prescribed by law for filing the income tax return (in

February 1, 1999 6 1999–5 I.R.B.

is hereby certified that these regulations do not have a significant impact on a substantial number of small entities. This certification is based upon the fact that the time required to prepare and file the election statement is minimal and will not have a significant impact on those small entities that choose to make the election. 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 preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is David Selig, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are 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. Section 1.195–1 is added to read as follows:

§1.195–1 Election to amortize start-up expenditures.

(a) In general. Under section 195(b), a taxpayer may elect to amortize start-up expenditures (as defined in section 195(c)(1)). A taxpayer who elects to amortize start-up expenditures must, at the time of the election, select an amortization period of not less than 60 months, beginning with the month in which the active trade or business begins. The election applies to all of the taxpayer’s startup expenditures with respect to the trade or business. The election to amortize

start-up expenditures is irrevocable, and the amortization period selected by the taxpayer in making the election may not subsequently be changed.

(b) Time and manner of making elec- tion. The election to amortize start-up expenditures under section 195 shall be made by attaching a statement containing the information described in paragraph (c) of this section to the taxpayer’s return. The statement must be filed no later than the date prescribed by law for filing the return (including any extensions of time) for the taxable year in which the active trade or business begins. The statement may be filed with a return for any taxable year prior to the year in which the taxpayer’s active trade or business begins, but no later than the date prescribed in the preceding sentence. Accordingly, an election under section 195 filed for any taxable year prior to the year in which the taxpayer’s active trade or business begins (and pursuant to which the taxpayer commenced amortizing start-up expenditures in that prior year) will become effective in the month of the year in which the taxpayer’s active trade or business begins.

(c) Information required. The statement shall set forth a description of the trade or business to which it relates with sufficient detail so that expenses relating to the trade or business can be identified properly for the taxable year in which the statement is filed and for all future taxable years to which it relates. The statement also shall include the number of months (not less than 60) over which the expenditures are to be amortized, and to the extent known at the time the statement is filed, a description of each start-up expenditure incurred (whether or not paid) and the month in which the active trade or business began (or was acquired). A revised statement may be filed to include any start-up expenditures not included in the taxpayer’s original election statement, but the revised statement may not include any expenditures for which the taxpayer had previously taken a position on a return inconsistent with their treatment as start-up expenditures. The revised statement may be filed with a return filed after the return that contained the election.

(d) Effective date. This section applies to elections filed on or after December 17, 1998.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 4. In §602.101, paragraph (c) is amended by adding an entry to the table in numerical order to read as follows:

§602.101 OMB Control numbers.

CFR part or section Current OMB where identified control No. and described

1.195–1 . . . . . . . . . . . . . . . . . 1545–1582

Bob Wenzel, Deputy Commissioner of

Internal Revenue.

Donald C. Lubick, Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on December 16, 1998, 8:45 a.m., and published in the issue of the Federal Register for December 17, 1998, 63 F.R. 69554)

Section 262.—Personal, Living, and Family Expenses

26 CFR 1.262–1: Personal, living, and family expenses.

For the rules to determine whether daily transportation expenses incurred by a taxpayer are deductible business expenses under § 162(a), see Rev. Rul. 99–7, page 4.

Section 664.—Charitable Remainder Trusts

26 CFR 1.664–1: Charitable remainder trusts.

T.D. 8791

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1, 25, and 602

1999–5 I.R.B 7 February 1, 1999

second method, the unitrust amount is determined under the net income method plus any amount of income that exceeds the current year’s fixed percentage amount to make up for any shortfall in payments from prior years when the trust income was less than the fixed percentage amount (NIMCRUT method). The shortfall in payments from prior years is commonly referred to as the “make-up amount.”

The revisions to the proposed regulations are discussed below.

I. Flip Unitrusts

Guidance Regarding Charitable Remainder Trusts and Special Valuation Rules for Transfers of Interests in Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to charitable remainder trusts and to special valuation rules for transfers of interests in trusts. The final regulations provide additional guidance regarding charitable remainder trusts. The final regulations affect charitable remainder trusts and their beneficiaries.

DATES: Effective date: These regulations are effective December 10, 1998.

Applicability dates: For dates of applicability of these regulations, see the explanations under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Mary Beth Collins or Jeff Erickson, (202) 622-3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 15451536. Responses to this collection of information are required to allow taxpayers alternative means of valuing a charitable remainder trust’s unmarketable assets.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

The estimated annual burden per respondent varies from .25 to .75 hours, depending on individual circumstances, with an estimated average of .5 hours.

Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS

Reports Clearance Officer, OP:FS:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Books or records relating to this collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

On April 18, 1997, the IRS published in the Federal Register (62 F.R. 19072) a notice of proposed rulemaking (REG– 209823–96, 1997–1 C.B. 763) regarding sections 664 and 2702. Comments responding to the proposed regulations were received, and a public hearing was held on November 18, 1997. After considering the comments received and the statements made at the public hearing, the proposed regulations are adopted as revised by this Treasury decision.

Explanation of Provisions

This document amends 26 CFR parts 1 and 25 to provide additional rules under sections 664 and 2702. Section 664 contains the rules for charitable remainder trusts (CRTs). In general, a CRT provides for a specified periodic distribution to one or more beneficiaries (at least one of whom is a noncharitable beneficiary) for life or for a term of years with an irrevocable remainder interest held for the benefit of charity.

There are two types of CRTs: a charitable remainder annuity trust (CRAT) and a charitable remainder unitrust (CRUT). A CRAT pays a sum certain at least annually to the beneficiaries (the annuity amount). A CRUT pays a unitrust amount at least annually to the beneficiaries. Generally, the unitrust amount is a fixed percentage of the net fair market value of the CRUT’s assets valued annually (fixed percentage CRUT). The unitrust amount can instead be calculated under one of two income exception methods (income exception CRUT). Under the first method, the unitrust amount is the lesser of the fixed percentage amount or the trust’s annual net income (net income method). Under the

A. Triggering Events

The proposed regulations provide specific rules for when a trust may convert from one of the income exception methods of computing the unitrust amount to the fixed percentage method (flip unitrust). The proposed rule was designed for taxpayers who ultimately wanted the unitrust amount to be computed on the fixed percentage method but funded the trust with unmarketable assets that generate little annual income. A number of commentators agreed with the policy underlying the proposed rule. Some commentators requested that we permit flip unitrusts for all income exception CRUTs regardless of the marketability of the trust assets. Other commentators suggested that the final regulations clarify whether the proposed rule was a safe harbor or the exclusive circumstance for which a flip unitrust would be permitted.

In response, the final regulations expand the availability of the flip unitrust to certain other situations that the IRS and Treasury believe are consistent with the legislative history indicating that a trustee should not have discretion to change the method used to calculate the unitrust amount. H.R. Conf. Rep. No. 782, 91st Cong., 1st Sess. 296 (1969), 1969–3 C.B. 644, 655. The final regulations allow the governing instrument of a CRUT to provide that the CRUT will convert once from one of the income exception methods to the fixed percentage method for calculating the unitrust amount if the date or event triggering the conversion is outside the control of the trustees or any other persons. The final regulations include examples of permissible and impermissible

February 1, 1999 8 1999–5 I.R.B.

triggering events. For example, permissible triggering events with respect to any individual include marriage, divorce, death, or birth of a child. Also, the sale of an unmarketable asset such as real estate is a permissible triggering event. Examples of impermissible triggering events include the sale of marketable assets and a request from the unitrust recipient or the unitrust recipient’s financial advisor that the trust convert to the fixed percentage method.

The final regulations also provide that the conversion to the fixed percentage method occurs at the beginning of the taxable year that immediately follows the taxable year in which the triggering date or event occurs. Any make-up amount described in section 664(d)(3)(B) is forfeited when the trust converts to the fixed percentage method.

The proposed regulations define unmarketable assets as assets other than cash, cash equivalents, or marketable securities (within the meaning of section 731(c)). Commentators asked for clarification of the term unmarketable assets and recommended changing the scope of this class of assets. In response, the final regulations define unmarketable assets as assets other than cash, cash equivalents, or assets that can be readily sold or exchanged for cash or cash equivalents. For example, unmarketable assets include real property, closely-held stock, and unregistered securities for which there is no available exemption permitting public sale.

Commentators requested that the final regulations permit conversions from the fixed percentage method to one of the income exception methods and conversions from a CRAT to a CRUT. The flip unitrust allowed in the final regulations is the only type of permissible conversion. Thus, a CRAT cannot convert to a CRUT without losing its status as a CRT. Similarly, a CRUT using the fixed percentage method cannot convert to an income exception method without losing its status as a CRT.

B. Effective Date and Transitional Rules

The rules for flip unitrusts are effective for CRUTs created on or after December 10, 1998. The proposed regulations allowed reformations in limited circumstances. In response to comments, the

final regulations expand the circumstances in which reformation is available. The final regulations allow income exception CRUTs to be reformed to add provisions allowing a conversion to the fixed percentage method provided the triggering event does not occur in a year prior to the year in which the court issues the order reforming the trust. Adding the conversion provisions will not cause the CRUT to fail to function exclusively as a CRT and will not be an act of self-dealing under section 4941 if the trustee initiates legal proceedings to reform the trust by June 8, 1999.

II. Time for Paying the Annuity Amount

or the Unitrust Amount

The proposed regulations provide that the payment of the annuity amount or the unitrust amount determined under the fixed percentage method must be made by the close of the taxable year in which it is due. The rules were proposed in response to abuses associated with the use of accelerated CRTs described in Notice 94–78 (1994–2 C.B. 555). After receiving a significant number of comments on the proposed rules, the IRS issued Notice 97–68 (1997–48 I.R.B. 11), which provided guidance on complying with the proposed rules for the 1997 taxable year.

One commentator recommended applying the proposed rules only to trusts created after the date the final regulations are published. Another commentator suggested adopting the rules in Notice 97–68 for all trusts created after a certain date. Although recent legislative changes have reduced the potential tax benefits of accelerated CRTs, the IRS and Treasury continue to be concerned about the potential abuse of the post-year-end grace period to produce a tax-free return of appreciation in the assets contributed to a CRAT or a fixed percentage CRUT. Therefore, the final regulations adopt rules similar to those in Notice 97–68 with certain modifications. The rules are effective for taxable years ending after April 18, 1997.

For CRATs and fixed percentage CRUTs, the annuity or unitrust amount may be paid within a reasonable time after the close of the year for which it is due if (a) the character of the annuity or unitrust amount in the recipient’s hands is

income under section 664(b)(1), (2), or (3); and/or (b) the trust distributes property (other than cash) that it owned as of the close of the taxable year to pay the annuity or unitrust amount and the trustee elects on Form 5227, “Split-Interest Trust Information Return,” to treat any income generated by the distribution as occurring on the last day of the taxable year for which the amount is due. In addition, for CRATs and fixed percentage CRUTs that were created before December 10, 1998, the annuity or unitrust amount may be paid within a reasonable time after the close of the taxable year for which it is due if the percentage used to calculate the annuity or unitrust amount is 15 percent or less.

III. Appraising Unmarketable Assets

Under section 664(d)(2)(A), a CRUT must value its assets annually. The proposed regulations provide that, if a CRT holds unmarketable assets and the only trustee is the grantor, a noncharitable beneficiary, or a related or subordinate party to the grantor or the noncharitable beneficiary within the meaning of section 672(c) and the applicable regulations, the trustee must value those assets using a current qualified appraisal, as defined in §1.170A–13(c)(3), from a qualified ap- praiser, as defined in §1.170A–13(c)(5).

The final regulations follow the proposed regulations and provide that the trust’s unmarketable assets must be valued by an independent trustee, or by a qualified appraisal from a qualified appraiser. The proposed regulations define an independent trustee as a person who is not the grantor, a noncharitable beneficiary or a related or subordinate party to the grantor, or the noncharitable beneficiary within the meaning of section 672(c) and the applicable regulations. The final regulations add the grantor’s spouse to the list of persons to whom an independent trustee cannot be related or subordinate. A co- trustee who is an independent trustee may value the trust’s unmarketable assets.

Finally, in response to comments, the final regulations define unmarketable assets as assets other than cash, cash equivalents, or assets that can be readily sold or exchanged for cash or cash equivalents. For example, unmarketable assets include

1999–5 I.R.B 9 February 1, 1999

real property, closely-held stock, and unregistered securities for which there is no available exemption permitting public sale.

The rules for valuing unmarketable assets are effective for trusts created on or after December 10, 1998.

IV. Application of Section 2702 to

Certain CRUTs

Under the proposed regulations, unitrust interests in an income exception CRUT that are retained by the donor or any applicable family member will be valued at zero when a noncharitable beneficiary of the trust is someone other than (1) the donor, (2) the donor’s U.S. citizen spouse, or (3) both the donor and the donor’s U.S. citizen spouse. Commentators stated that income exception CRUTs without a make-up provision should be exempt from section 2702. The IRS and Treasury believe that, in addition to the NIMCRUT method, the net income method can be used to circumvent the intent of section 2702. Therefore, the final regulations do not exempt from section 2702 CRUTs that use only the net income method.

Commentators also stated that the proposed rule encompassed other transfers that section 2702 was not intended to include. A commentator noted that the proposed rule would value a transferor’s interest at zero even though the transferor merely retained a secondary life estate. The final regulations clarify that section 2702 will not apply when there are only two consecutive noncharitable beneficial interests and the transferor holds the second of the two interests.

Commentators also asked whether section 2702 may apply to flip unitrusts. The potential abuse associated with income exception CRUTs also exists with flip unitrusts. Therefore, under the final regulations, section 2702 applies to a flip unitrust if the CRUT does not fall within one of the exemptions.

sets when contributed to the trust, must be allocated to trust principal. Some commentators stated that the rule is inconsistent with the rule concerning income under section 643(b). Other commentators questioned whether the make-up amount under the NIMCRUT method should be treated as a liability when valuing the trust’s assets.

The final regulations maintain the prohibition on allocating precontribution gain to trust income for an income exception CRUT. However, the governing instrument, if permitted under applicable local law, may allow the allocation of post-contribution capital gains to trust income. Taxpayers do not have to treat the make-up amount as a liability when valuing the assets of a NIMCRUT.

Drafting Information

The principal authors of these regulations are Mary Beth Collins and Jeff Erickson, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from offices of the IRS and Treasury Department participated in their development.

- - - -

Adoption of Amendments to the Regulations

Accordingly, CFR parts 1, 25, and 602 are 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 §1.664–1, paragraphs (a)(7) and (d)(1)(iii) are added, and paragraph (f)(4) is added following the concluding text of paragraph (f)(3) to read as follows:

§1.664–1 Charitable remainder trusts.

(a) * * * (7) Valuation of unmarketable assets (i) In general. If unmarketable assets are transferred to or held by a trust, the trust will not be a trust with respect to which a deduction is available under section 170, 2055, 2106, or 2522, or will be treated as failing to function exclusively as a charitable remainder trust unless, whenever the trust is required to value such assets, the valuation is—

( a ) Performed exclusively by an independent trustee; or

( b ) Determined by a current qualified appraisal, as defined in §1.170A–13(c)(3), from a qualified appraiser, as defined in §1.170A–13(c)(5).

(ii) Unmarketable assets . Unmarketable assets are assets that are not cash, cash equivalents, or other assets that can be readily sold or exchanged for cash or cash equivalents. For example, unmarketable assets include real property, closely-held stock, and an unregistered security for which there is no available exemption permitting public sale.

(iii) Independent trustee. An independent trustee is a person who is not the grantor of the trust, a noncharitable bene

V. Prohibition on Allocating

Precontribution Gain to Trust Income and Make-up Amount as a Liability

The proposed regulations clarify that the proceeds from the sale of an income exception CRUT’s assets, at least to the extent of the fair market value of the as

VI. Example Illustrating Rule for

Characterizing Distributions from CRUTs

The proposed regulations contain an example of how the ordering rule under section 664(b) operates when the unitrust amount is computed under an income exception method. No comments were received on this example. Thus, the final regulations adopt the example without any changes.

Effect on Other Documents

Notice 97–68 (1997–48 I.R.B. 11) is obsolete as of December 10, 1998.

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. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f), the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

February 1, 1999 10 1999–5 I.R.B.

ficiary, or a related or subordinate party to the grantor, the grantor’s spouse, or a noncharitable beneficiary (within the meaning of section 672(c) and the applicable regulations).

(d) * * * (1) * * * (iii) Example. The following example illustrates the application of this paragraph (d)(1):

Example. (i) X is a charitable remainder unitrust described in section 664(d)(2) and (3). The annual unitrust amount is the lesser of the amount of trust income, as defined in §1.664–3(a)(1)(i)(b), or six percent of the net fair market value of the trust assets valued annually. The net fair market value of the trust assets on the valuation date in 1996 is $150,000. During 1996, X has $7,500 of income after allocating all expenses. All of X ’s income for 1996 is tax-exempt income. At the end of 1996, X ’s ordinary income for the current taxable year and undistributed ordinary income for prior years are both zero; X ’s capital gain for the current taxable year is zero and undistributed capital gain for prior years is $30,000; and X ’s tax-exempt income for the current year is $7,500 and undistributed tax-exempt income for prior years is $2,500.

(ii) Because the trust income of $7,500 is less than the fixed percentage amount of $9,000, the unitrust amount for 1996 is $7,500. The character of that amount in the hands of the recipient of the unitrust amount is determined under section 664(b). Because the unitrust amount is less than X ’s undistributed capital gain income, the recipient of the unitrust amount treats the distribution of $7,500 as capital gain. At the beginning of 1997, X ’s undistributed capital gain for prior years is reduced to $22,500, and X ’s undistributed tax-exempt income is increased to $10,000.

(f) * * * (4) Valuation of unmarketable assets. The rules contained in paragraph (a)(7) of this section are applicable for trusts created on or after December 10, 1998. A trust in existence as of December 10, 1998, whose governing instrument requires that an independent trustee value the trust’s unmarketable assets may be amended or reformed to permit a valuation method that satisfies the requirements of paragraph (a)(7) of this section for taxable years beginning on or after December 10, 1998.

Par. 3. In §1.664–2, paragraph (a)(1)(i) is revised to read as follows:

§1.664–2 Charitable remainder annuity trust.

(a) * * * (1) * * * (i) Payment of sum certain at least annually. The governing instrument provides that the trust will pay a sum certain not less often than annually to a person or persons described in paragraph (a)(3) of this section for each taxable year of the period specified in paragraph (a)(5) of this section.

( a ) General rule applicable to all trusts. A trust will not be deemed to have engaged in an act of self-dealing (within the meaning of section 4941), to have unrelated debt-financed income (within the meaning of section 514), to have received an additional contribution (within the meaning of paragraph (b) of this section), or to have failed to function exclusively as a charitable remainder trust (within the meaning of §1.664–1(a)(4)) merely because the annuity amount is paid after the close of the taxable year if such payment is made within a reasonable time after the close of such taxable year and the entire annuity amount in the hands of the recipient is characterized only as income from the categories described in section 664(b)(1), (2), or (3), except to the extent it is characterized as corpus described in section 664(b)(4) because—

( 1 ) The trust distributes property (other than cash) that it owned at the close of the taxable year to pay the annuity amount; and

( 2 ) The trustee elects to treat any income generated by the distribution as occurring on the last day of the taxable year in which the annuity amount is due.

( b ) Special rule for trusts created be- fore December 10, 1998. In addition, to the circumstances described in paragraph (a)(1)(i)(a) of this section, a trust created before December 10, 1998, will not be deemed to have engaged in an act of selfdealing (within the meaning of section 4941), to have unrelated debt-financed income (within the meaning of section 514), to have received an additional contribution (within the meaning of paragraph (b) of this section), or to have failed to function exclusively as a charitable remainder trust (within the meaning of §1.664–1(a)(4)) merely because the annuity amount is paid after the close of the taxable year if such payment is made within a reasonable time after the close of such taxable year and the sum certain to be paid each year as the annuity amount is

15 percent or less of the initial net fair market value of the property irrevocably passing in trust as determined for federal tax purposes.

( c ) Reasonable time. For this paragraph (a)(1)(i), a reasonable time will not ordinarily extend beyond the date by which the trustee is required to file Form 5227, “Split-Interest Trust Information Return,” (including extensions) for the taxable year.

( d ) Example. The following example illustrates the rules in paragraph (a)(1)(i)(a) of this section:

Example. X is a charitable remainder annuity trust described in section 664(d)(1) that was created after December 10, 1998. The prorated annuity amount payable from X for Year 1 is $100. The trustee does not pay the annuity amount to the recipient by the close of Year 1. At the end of Year 1, X has only $95 in the ordinary income category under section 664(b)(1) and no income in the capital gain or tax-exempt income categories under section 664(b)(2) or (3), respectively. By April 15 of Year 2, in addition to $95 in cash, the trustee distributes to the recipient of the annuity a capital asset with a $5 fair market value and a $2 adjusted basis to pay the $100 annuity amount due for Year 1. The trust owned the asset at the end of Year 1. Under §1.664– 1(d)(5), the distribution is treated as a sale by X, resulting in X recognizing a $3 capital gain. The trustee elects to treat the capital gain as occurring on the last day of Year 1. Under §1.664–1(d)(1), the character of the annuity amount for Year 1 in the recipient’s hands is $95 of ordinary income, $3 of capital gain income, and $2 of trust corpus. For Year 1, X satisfied paragraph (a)(1)(i)(a) of this section.

( e ) Effective date. This paragraph (a)(1)(i) is applicable for taxable years ending after April 18, 1997.

Par. 4. Section 1.664–3 is amended as follows:

Paragraphs (a)(1)(i)( a ), (a)(1)(i)( b )( 1 ), and (a)(1)(i)( b )( 2 ) are revised.
Paragraphs (a)(1)(i)( b )( 3 ), (a)(1)(i)( b )( 4 ), (a)(1)(i)( b )( 5 ), and (a)(1)(i)( c ) through (a)(1)(i)(l) are added.
The third sentence of paragraph (a)(1)(iv) is revised.

The added and revised provisions read as follows:

§1.664–3 Charitable remainder unitrust.

(a) * * * (1) * * * (i) * * * (a) General rule. The governing instrument provides that the trust will pay not less often than annually a fixed percentage of the net fair market

1999–5 I.R.B 11 February 1, 1999

value of the trust assets determined annually to a person or persons described in paragraph (a)(3) of this section for each taxable year of the period specified in paragraph (a)(5) of this section. This paragraph (a)(1)(i)( a ) is applicable for taxable years ending after April 18, 1997.

( b ) * * * ( 1 ) The amount of trust income for a taxable year to the extent that such amount is not more than the amount required to be distributed under paragraph (a)(1)(i)( a ) of this section.

( 2 ) An amount of trust income for a taxable year that is in excess of the amount required to be distributed under paragraph (a)(1)(i)( a ) of this section for such year to the extent that (by reason of paragraph (a)(1)(i)( b )( 1 ) of this section) the aggregate of the amounts paid in prior years was less than the aggregate of such required amounts.

( 3 ) For this paragraph (a)(1)(i)( b ), trust income means income as defined under section 643(b) and the applicable regulations.

( 4 ) For this paragraph (a)(1)(i)( b ), proceeds from the sale or exchange of any assets contributed to the trust by the donor must be allocated to principal and not to trust income at least to the extent of the fair market value of those assets on the date of contribution.

( 5 ) The rules in paragraphs (a)(1)(i)( b )( 1 ), ( 2 ), and ( 3 ) of this section are applicable for taxable years ending after

April 18, 1997, and the rule in paragraph (a)(1)(i)( b )( 4 ) of this section is applicable for sales or exchanges that occur after April 18, 1997.

(c) Combination of methods . Instead of the amount described in paragraph (a)(1)(i)( a ) or ( b ) of this section, the governing instrument may provide that the trust will pay not less often than annually the amount described in paragraph (a)(1)(i)( b ) of this section for an initial period and then pay the amount described in paragraph (a)(1)(i)( a ) of this section (calculated using the same fixed percentage) for the remaining years of the trust only if the governing instrument provides that—

( 1 ) The change from the method prescribed in paragraph (a)(1)(i)( b ) of this section to the method prescribed in paragraph (a)(1)(i)( a ) of this section is triggered on a specific date or by a single event whose occurrence is not discre

tionary with, or within the control of, the trustees or any other persons;

( 2 ) The change from the method prescribed in paragraph (a)(1)(i)( b ) of this section to the method prescribed in paragraph (a)(1)(i)( a ) of this section occurs at the beginning of the taxable year that immediately follows the taxable year during which the date or event specified under paragraph (a)(1)(i)( c )( 1 ) of this section occurs; and

( 3 ) Following the trust’s conversion to the method described in paragraph (a)(1)(i)( a ) of this section, the trust will pay at least annually to the permissible recipients the amount described only in paragraph (a)(1)(i)( a ) of this section and not any amount described in paragraph (a)(1)(i)( b ) of this section.

( d ) Triggering event. For purposes of paragraph (a)(1)(i)( c )( 1 ) of this section, a triggering event based on the sale of unmarketable assets as defined in §1.664– 1(a)(7)(ii), or the marriage, divorce, death, or birth of a child with respect to any individual will not be considered discretionary with, or within the control of, the trustees or any other persons.

( e ) Examples. The following examples illustrate the rules in paragraph (a)(1)(i)( c ) of this section. For each example, assume that the governing instrument of charitable remainder unitrust Y provides that Y will initially pay not less often than annually the amount described in paragraph (a)(1)(i)( b ) of this section and then pay the amount described in paragraph (a)(1)(i)( a ) of this section (calculated using the same fixed percentage) for the remaining years of the trust and that the requirements of paragraphs (a)(1)(i)( c )( 2 ) and ( 3 ) of this section are satisfied. The examples are as follows:

Example 1. Y is funded with the donor’s former personal residence. The governing instrument of Y provides for the change in method for computing the annual unitrust amount as of the first day of the year following the year in which the trust sells the residence. Y provides for a combination of methods that satisfies paragraph (a)(1)(i)(c) of this section.

Example 2. Y is funded with cash and an unregistered security for which there is no available exemption permitting public sale under the Securities and Exchange Commission rules. The governing instrument of Y provides that the change in method for computing the annual unitrust amount is triggered on the earlier of the date when the stock is sold or at the time the restrictions on its public sale lapse or are otherwise lifted. Y provides for a combination of methods that satisfies paragraph (a)(1)(i)(c) of this section.

Example 3. Y is funded with cash and with a security that may be publicly traded under the Securities and Exchange Commission rules. The governing instrument of Y provides that the change in method for computing the annual unitrust amount is triggered when the stock is sold. Y does not provide for a combination of methods that satisfies the requirements of paragraph (a)(1)(i)( c ) of this section because the sale of the publicly-traded stock is within the discretion of the trustee.

Example 4. S establishes Y for her granddaughter, G, when G is 10 years old. The governing instrument of Y provides for the change in method for computing the annual unitrust amount as of the first day of the year following the year in which G turns 18 years old. Y provides for a combination of methods that satisfies paragraph (a)(1)(i)(c) of this section.

Example 5 . The governing instrument of Y provides for the change in method for computing the annual unitrust amount as of the first day of the year following the year in which the donor is married. Y provides for a combination of methods that satisfies paragraph (a)(1)(i)(c) of this section.

Example 6 . The governing instrument of Y provides that if the donor divorces, the change in method for computing the annual unitrust amount will occur as of the first day of the year following the year of the divorce. Y provides for a combination of methods that satisfies paragraph (a)(1)(i)( c ) of this section.

Example 7 . The governing instrument of Y provides for the change in method for computing the annual unitrust amount as of the first day of the year following the year in which the noncharitable beneficiary’s first child is born. Y provides for a combination of methods that satisfies paragraph (a)(1)(i)( c ) of this section.

Example 8. The governing instrument of Y provides for the change in method for computing the annual unitrust amount as of the first day of the year following the year in which the noncharitable beneficiary’s father dies. Y provides for a combination of methods that satisfies paragraph (a)(1)(i)( c ) of this section.

Example 9. The governing instrument of Y provides for the change in method for computing the annual unitrust amount as of the first day of the year following the year in which the noncharitable beneficiary’s financial advisor determines that the beneficiary should begin receiving payments under the second prescribed payment method. Because the change in methods for paying the unitrust amount is triggered by an event that is within a person’s control, Y does not provide for a combination of methods that satisfies paragraph (a)(1)(i)( c ) of this section.

Example 10. The governing instrument of Y provides for the change in method for computing the annual unitrust amount as of the first day of the year following the year in which the noncharitable beneficiary submits a request to the trustee that the trust convert to the second prescribed payment method. Because the change in methods for paying the unitrust amount is triggered by an event that is within a person’s control, Y does not provide for a combination of methods that satisfies paragraph (a)(1)(i)( c ) of this section.

(f) Effective date —( 1 ) General rule. Paragraphs (a)(1)(i)(c), (d), and (e) of this

February 1, 1999 12 1999–5 I.R.B.

is made within a reasonable time after the close of such taxable year and the fixed percentage to be paid each year as the unitrust amount is 15 percent or less of the net fair market value of the trust assets as determined under paragraph (a)(1)(iv) of this section.

( i ) Example. The following example illustrates the rules in paragraph (a)(1)(i)(g) of this section:

Example. X is a charitable remainder unitrust that calculates the unitrust amount under paragraph (a)(1)(i)(a) of this section. X was created after December 10, 1998. The prorated unitrust amount payable from X for Year 1 is $100. The trustee does not pay the unitrust amount to the recipient by the end of the Year 1. At the end of Year 1, X has only $95 in the ordinary income category under section 664(b)(1) and no income in the capital gain or taxexempt income categories under section 664(b)(2) or (3), respectively. By April 15 of Year 2, in addition to $95 in cash, the trustee distributes to the unitrust recipient a capital asset with a $5 fair market value and a $2 adjusted basis to pay the $100 unitrust amount due for Year 1. The trust owned the asset at the end of Year 1. Under §1.664–1(d)(5), the distribution is treated as a sale by X, resulting in X recognizing a $3 capital gain. The trustee elects to treat the capital gain as occurring on the last day of Year 1. Under §1.664–1(d)(1), the character of the unitrust amount for Year 1 in the recipient’s hands is $95 of ordinary income, $3 of capital gain income, and $2 of trust corpus. For Year 1, X satisfied paragraph (a)(1)(i)( g ) of this section.

( j ) Payment under income exception. When the unitrust amount is computed under paragraph (a)(1)(i)(b) of this section, a trust will not be deemed to have engaged in an act of self-dealing (within the meaning of section 4941), to have unrelated debt-financed income (within the meaning of section 514), to have received an additional contribution (within the meaning of paragraph (b) of this section), or to have failed to function exclusively as a charitable remainder trust (within the meaning of §1.664–1(a)(4)) merely because payment of the unitrust amount is made after the close of the taxable year if such payment is made within a reasonable time after the close of such taxable year.

( k ) Reasonable time. For paragraphs (a)(1)(i)(g), (h), and (j) of this section, a reasonable time will not ordinarily extend beyond the date by which the trustee is required to file Form 5227, “Split-Interest Trust Information Return,” (including extensions) for the taxable year.

( l ) Effective date. Paragraphs (a)(1)(i)(g), (h), (i), (j), and (k) of this section are

section are applicable for charitable remainder trusts created on or after December 10, 1998.

( 2 ) General rule regarding reforma- tions of combination of method unitrusts. If a trust is created on or after December 10, 1998, and contains a provision allowing a change in calculating the unitrust amount that does not comply with the provisions of paragraph (a)(1)(i)( c ) of this section, the trust will qualify as a charitable remainder unitrust only if it is amended or reformed to use the initial method for computing the unitrust amount throughout the term of the trust, or is reformed in accordance with paragraph (a)(1)(i)( f )( 3 ) of this section. If a trust was created before December 10, 1998, and contains a provision allowing a change in calculating the unitrust amount that does not comply with the provisions of paragraph (a)(1)(i)( c ) of this section, the trust may be reformed to use the initial method for computing the unitrust amount throughout the term of the trust without causing the trust to fail to function exclusively as a charitable remainder unitrust under §1.664–1(a)(4), or may be reformed in accordance with paragraph (a)(1)(i)( f )( 3 ) of this section. Except as provided in paragraph (a)(1)(i)( f )( 3 ) of this section, a qualified charitable remainder unitrust will not continue to qualify as a charitable remainder unitrust if it is amended or reformed to add a provision allowing a change in the method for calculating the unitrust amount.

(3) Special rule for reformations of trusts that begin by June 8, 1999. Notwithstanding paragraph (a)(1)(i)( f )( 2 ) of this section, if a trust either provides for payment of the unitrust amount under a combination of methods that is not permitted under paragraph (a)(1)(i)( c ) of this section, or provides for payment of the unitrust amount under only the method prescribed in paragraph (a)(1)(i)( b ) of this section, then the trust may be reformed to allow for a combination of methods permitted under paragraph (a)(1)(i)( c ) of this section without causing the trust to fail to function exclusively as a charitable remainder unitrust under §1.664–1(a)(4) or to engage in an act of self-dealing under section 4941 if the trustee begins legal proceedings to reform by June 8, 1999. The triggering event under the reformed governing instrument may not occur in a

year prior to the year in which the court issues the order reforming the trust, except for situations in which the governing instrument prior to reformation already provided for payment of the unitrust amount under a combination of methods that is not permitted under paragraph (a)(1)(i)( c ) of this section and the triggering event occurred prior to the reformation.

( g ) Payment under general rule for fixed percentage trusts. When the unitrust amount is computed under paragraph (a)(1)(i)( a ) of this section, a trust will not be deemed to have engaged in an act of self-dealing (within the meaning of section 4941), to have unrelated debt-financed income (within the meaning of section 514), to have received an additional contribution (within the meaning of paragraph (b) of this section), or to have failed to function exclusively as a charitable remainder trust (within the meaning of §1.664–1(a)(4)) merely because the unitrust amount is paid after the close of the taxable year if such payment is made within a reasonable time after the close of such taxable year and the entire unitrust amount in the hands of the recipient is characterized only as income from the categories described in section 664(b)(1), (2), or (3), except to the extent it is characterized as corpus described in section 664(b)(4) because— ( 1 ) The trust distributes property (other than cash) that it owned at the close of the taxable year to pay the unitrust amount; and

( 2 ) The trustee elects to treat any income generated by the distribution as occurring on the last day of the taxable year for which the unitrust amount is due.

( h ) Special rule for fixed percentage trusts created before December 10, 1998. When the unitrust amount is computed under paragraph (a)(1)(i)(a) of this section, a trust created before December 10, 1998, will not be deemed to have engaged in an act of self-dealing (within the meaning of section 4941), to have unrelated debt-financed income (within the meaning of section 514), to have received an additional contribution (within the meaning of paragraph (b) of this section), or to have failed to function exclusively as a charitable remainder trust (within the meaning of §1.664–1(a)(4)) merely because the unitrust amount is paid after the close of the taxable year if such payment

1999–5 I.R.B 13 February 1, 1999

applicable for taxable years ending after April 18, 1997.

(iv) * * * If the governing instrument does not specify the valuation date or dates, the trustee must select such date or dates and indicate the selection on the first return on Form 5227, “Split-Interest Trust Information Return,” that the trust must file. * * *

PART 25—GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

Par. 5. The authority citation for part 25 continues to read in part as follows: Authority: 26 U.S.C. 7805. * * * Par. 6. In §25.2702–1, paragraph (c)(3) is revised to read as follows:

§25.2702–1 Special valuation rules in the case of transfers of interests in trust.

(c) * * * (3) Charitable remainder trust. (i) For transfers made on or after May 19, 1997, a transfer to a pooled income fund described in section 642(c)(5); a transfer to a charitable remainder annuity trust described in section 664(d)(1); a transfer to a charitable remainder unitrust described in section 664(d)(2) if under the terms of the governing instrument the unitrust amount can be computed only under section 664(d)(2)(A); and a transfer to a charitable remainder unitrust if under the terms of the governing instrument the unitrust amount can be computed under section 664(d)(2) and (3) and either there are only two consecutive noncharitable beneficial interests and the transferor holds the second of the two interests, or the only permissible recipients of the unitrust amount are the transferor, the transferor’s U.S. citizen spouse, or both the transferor and the transferor’s U.S. citizen spouse.

(ii) For transfers made before May 19, 1997, a transfer in trust if the remainder interest in the trust qualifies for a deduction under section 2522.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 7. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 8. In §602.101, paragraph (c) is amended by revising the entry for §1.6641 to read as follows:

§602.101 OMB Control numbers.

CFR part or section Current OMB where identified control No. and described

1.664–1 . . . . . . . . . . . . . . . . . 1545–1536

Robert E. Wenzel,

Deputy Commissioner of

Internal Revenue.

Approved December 1, 1998.

Donald C. Lubick, Assistant Secretary of

the Treasury,

(Tax Policy).

(Filed by the Office of the Federal Register on December 9, 1998, 8:45 a.m., and published in the issue of the Federal Register for December 10, 1998, 63 F.R. 68188)

Section 865.—Source Rules for Personal Property Sales

26 CFR 1.865–1T: Loss with respect to personal property other than stock (Temporary).

T.D. 8805

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Allocation of Loss with Respect to Stock and Other Personal Property; Application of Section 904 to Income Subject to Separate Limitations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains final and temporary Income Tax Regulations relating to the allocation of loss recognized on the disposition of stock and other personal property and the computation of the foreign tax credit limitation. The loss allocation regulations primarily will affect taxpayers that claim the foreign tax credit and that incur losses with respect to personal property and are necessary to modify existing guidance with respect to loss allocation. The foreign tax credit limitation regulations will affect taxpayers claiming foreign tax credits that have passive income or losses and are necessary to modify existing guidance with respect to the computation of the limitation.

DATES: Effective dates: These regulations are effective January 11, 1999, except that §1.904–4(c)(2)(ii)(A) and (B) are effective March 12, 1999 and §1.904– 4(c)(3)(iv) is effective December 31, 1998. Dates of applicability: For dates of applicability of §§1.865–1T, 1.865–2, and 1.865–2T, see §§1.865–1T(f), 1.865–2(e), and 1.865–2T(e), respectively. For dates of applicability of §1.904–4(c), see §1.904–4(c)(2)(i).

FOR FURTHER INFORMATION CONTACT: Seth B. Goldstein, (202) 6223810, regarding section 865(j); and Rebecca Rosenberg, (202) 622-3850, regarding section 904(d) (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

On May 14, 1992, the IRS published a notice of proposed rulemaking in the Fed- eral Register (REG–209527–92, formerly INTL–1–92 (1992–1 C.B. 1209), 57 F.R. 20660), proposing amendments to the Income Tax Regulations (26 CFR part

under section 904(d). The regulations included proposed amendments to the grouping rules under §1.904–4(c)(3) for purposes of determining whether passive income is high taxed. The amendments were proposed to be effective for taxable years beginning after December 31, 1991. A public hearing was held on September 24, 1992, but no written or oral comments

February 1, 1999 14 1999–5 I.R.B.

were received with respect to these provisions. These regulations are finalized as proposed. However, as described below, the effective date of the regulations has been modified.

On July 8, 1996, the IRS published proposed amendments (REG–209750–95, formerly INTL–4–95 (1996–2 C.B. 484), 61 F.R. 35696) to the Income Tax Regulations (26 CFR part 1) under sections 861, 865, and 904 of the Internal Revenue Code in the Federal Register. The regulations addressed the allocation of loss on the disposition of stock (§1.865–2) and other personal property (§1.865–1) and also contained proposed amendments to the grouping rules under §1.904–4(c). The proposed regulations generally allocate loss with respect to stock based upon the residence of the seller (reciprocal to gain), but allocate loss on other personal property based upon the income generated by the property. A public hearing was held on November 6, 1996, and several written comments were received. The written comments endorsed the regulations’ general approach with respect to the allocation of stock loss. In addition, on June 18, 1997, the Tax Court held in International Multifoods Corporation v. Commissioner, 108 T.C. 579 (1997), that loss on the disposition of stock is generally allocated based on the residence of the seller, consistent with the approach of the proposed regulations. After consideration of all the comments, the regulations proposed by INTL–4–95 with respect to stock loss and with respect to the grouping rules are adopted as amended by this Treasury decision. The principal changes to these regulations, as well as the major comments and suggestions, are discussed below. An additional anti-abuse rule, not previously proposed, is issued as a proposed and temporary regulation.

The written comments criticized the proposed regulation concerning the allocation of loss on other personal property (§1.865–1). This proposed regulation is withdrawn and replaced with a new proposed and temporary regulation that is more consistent with the approach of the stock loss allocation rules. The new rules are issued as a temporary regulation because of the need for immediate guidance following the International Multifoods opinion.

Explanation of Provisions

Section 1.861-8T(e)(8): Net Operating Loss

Section 1.861–8T(e)(8) clarifies that a net operating loss deduction allowed under section 172 is allocated and apportioned in the same manner as the deductions giving rise to the net operating loss deduction.

Section 1.865–1T: Loss With Respect to Personal Property Other Than Stock

Section 1.865–1T(a) provides the general rule that loss with respect to personal property is allocated in the same manner in which gain on the sale of the property would be sourced. Thus, for example, loss on the sale or worthlessness of a foreign bond held by a U.S. resident generally would be allocated against U.S. source income. Notice 89–58 (1989–1 C.B. 699), which addressed the allocation of loss with respect to certain bank loans, is revoked as inconsistent with this approach. Taxpayers may rely on the Notice for loss recognized prior to the effective date of the temporary regulations (see discussion of effective dates, below). Following the general rule, loss attributable to a foreign office of a U.S. resident is allocated against foreign source income where gain would be foreign source under the foreign branch rule of section 865(e)(1).

Section 1.865–1T(b) provides special rules of application. Loss on depreciable property generally is allocated based upon the allocation of depreciation deductions taken with respect to the property, consistent with the depreciation-recapture source rule of section 865(c)(1). Similarly, loss with respect to a contingent payment debt instrument subject to Reg. §1.1275–4(b) is allocated against interest income because gain on the instrument generally is treated as interest income.

Section 1.865–1T(c) provides exceptions from the reciprocal-to-gain rule. The regulations do not apply to certain financial products (to be addressed in a future guidance project), loss governed by section 988, inventory (which is not governed by section 865), or trade receivables and certain interest equivalents (which are governed by §1.861–9T(b)). When Prop. §1.863–3(h) (the global dealing sourcing regulation) is finalized, §1.865–1T will

not apply to any loss sourced under that regulation. Loss attributable to accruedbut-unpaid interest income is allocated against interest income. Also, loss on a debt instrument is allocated against interest income to the extent the taxpayer did not amortize bond premium to the full extent permitted by the Code. Anti-abuse exceptions are also provided. Section 1.865–1T(c)(6)(i), which prevents taxpayers from manipulating loss allocation through related-party transfers, reorganizations, or similar transactions, and §1.865–1T(c)(6)(ii), which addresses offsetting positions, are similar to the antiabuse rules previously proposed with respect to stock losses. In addition, section 1.865–1T(c)(6)(iii) has been included to prevent taxpayers from accelerating foreign source income with respect to property and claiming an offsetting U.S. loss.

The temporary regulations are effective for loss recognized on or after January 11, 1999. A taxpayer may apply the regulations, however, to loss recognized in any taxable year beginning on or after January 1, 1987, subject to certain conditions.

Section 1.865–2: Stock Loss

The proposed regulations issued in 1996 provide that generally loss with respect to stock is allocated to the residence of the seller, but contain three major exceptions: an exclusion for dispositions of portfolio stock and stock in regulated investment companies (RICs) and S corporations, a dividend recapture rule, and a consistency rule for certain dispositions of foreign affiliates. The final regulations modify these exceptions. The principal comments and changes to the regulations are discussed below.

Section 1.865–2(a): General Rule for Allocation of Stock Loss

Commentators criticized the exclusion of portfolio stock and RIC stock from the general residence-based rule, arguing that the rationale for residence-based allocation applies equally to these classes of stock. The final regulations eliminate the exception for portfolio stock and RIC stock.

In response to a comment, the final regulations clarify that §1.865–2 does not apply to stock that constitutes inventory.

The proposed regulations allocate loss recognized on the “sale or other disposi

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tion” of stock. Proposed §1.865–2(c)(2) provides that worthlessness giving rise to a deduction under section 165(g)(3) with respect to stock is treated as a disposition. Questions have been raised as to whether the regulations apply to other recognized losses that are not the result of a sale or disposition (for example, loss recognized under the mark-to-market rules of section 475). The final regulations are intended to apply to all recognized stock losses. To avoid confusion, the reference to sales or other dispositions has been deleted in the final regulations. The special reference to worthlessness deductions is therefore unnecessary and also has been deleted.

Section 1.865–2(b)(1): Dividend Recapture Exception

Some commentators questioned the dividend recapture rule of §1.865–2(b)(1) and suggested that the rule should be limited to cases in which the dividends were fully sheltered from U.S. tax by foreign tax credits or the taxpayer did not meet a minimum holding period. Others suggested that the two-year recapture period defined in §1.865–2(d)(5) of the proposed regulations should be shortened. Sections 1.865–2(b)(1)(i) and 1.865–2(d)(3) of the final regulations retain the two-year rule.

Section 1.865–2(b)(1)(iii) of the final regulations provides an exception from dividend recapture for passive-basket dividends. This new exception will exempt most portfolio investors (other than financial services entities) from the dividend recapture rule. The rule, which will reduce administrative burdens, reflects the fact that passive income is generally subject to residual U.S. tax and the high-tax kick-out of section 904(d)(2)(A)(iii)(III) limits the potential for cross-crediting in the passive basket, thus reducing the need for recapture. In addition, allocation of loss to the passive basket may lead to investment incentives that violate the policies underlying the passive basket. For example, where a loss allocated to the passive basket creates a separate limitation loss under section 904(f)(5) that reduces high-taxed income in other baskets, this creates an incentive in subsequent years for the taxpayer to earn low-taxed foreign passive income to utilize the foreign tax credits in the high-taxed basket (due to the recharacterization rules of section 904(f)(5)(C)).

Commentators also suggested alternatives to the de minimis rule of §1.865– 2(b)(1)(ii), which exempts from recapture dividends that are less than 10 percent of the recognized loss. The proposed de minimis rule is retained in the final regulations. The de minimis rule is intended to exempt from recapture, as a matter of administrative convenience, dividends that are relatively insignificant in comparison to the loss.

Two commentators questioned why the dividend recapture rule and the definition of the recapture period in §1.865–2(d)(5) of the proposed regulations refer to realized, rather than recognized, loss. The wording was intended to avoid confusion over the application of the rule to loss that is deferred under section 267(f). The final regulation refers to “recognized” loss, but examples have been added in §1.865– 2(b)(1)(iv) of the final regulations to illustrate the application of the dividend recapture rule in the context of section 267(f) and how the result differs in the context of a consolidated group.

Proposed §1.865–2(b)(2): Consistency Rule

Proposed §1.865–2(b)(2) requires a taxpayer to allocate loss on the sale of a foreign affiliate to passive-basket foreign source income if the taxpayer recognized foreign source gain under section 865(f) at any time during the 5-year period preceding the loss sale. Commentators criticized this rule as producing disproportionate results where the foreign source gain is small in comparison to the subsequent loss. Furthermore, even where the gain and loss are of similar magnitude, the results may be disproportionate because sourcing the gain foreign may provide the taxpayer with minimal tax benefits (because the gain is assigned to the passive basket) but the loss may reduce (sometimes as a separate limitation loss) income that is otherwise sheltered by foreign tax credits. In addition, allocating loss to the passive basket raises the policy concerns described above with respect to passive-basket dividend recapture. After consideration of the comments, the consistency rule has been eliminated from the final regulations.

Section 1.865–2(b)(2): Anti-abuse Rules

The anti-abuse rules of §1.865–2(b)(3)

of the proposed regulations, finalized as §1.865–2(b)(4), have been refined and modified. One commentator requested examples illustrating the anti-abuse rules. Examples have been provided. An additional rule is provided in §1.865–2T, discussed below.

Section 1.865–2(e): Effective Date and Retroactive Election

The proposed regulations are proposed to be effective for taxable years beginning 61 days after final regulations are promulgated. Because of the immediate need for guidance following the International Multifoods opinion, the final regulations are effective for losses recognized on or after January 11, 1999.

Several commentators requested that the regulations clarify the scope of the retroactive election and reduce the administrative burden of making the election. In response to these comments, §1.865– 2(e)(2) is amended to provide that a taxpayer need not make a formal election to retroactively apply the regulations to losses recognized in any post-1986 year and all subsequent pre-effective date years. An amended return will be required only if retroactive application results in a change in tax liability.

One commentator urged that the overall foreign loss transition rule in §1.904(f)–12 be modified to provide that an overall foreign loss account attributable to a stock loss recognized in a pre-1987 year be recomputed under the new regulations in the first election year. This suggestion was rejected because the allocation of a stock loss is governed by the rules in effect in the year the loss is recognized, and the retroactive election is available only with respect to post-1986 years. Section 1.865–2(e)(3) provides examples to illustrate the effect of the retroactive application of the regulations on overall foreign loss accounts, capital loss carryovers, and foreign tax credit carryovers.

Section 1.865–2T: Stock Loss Matching Rule

Section 1.865–2T(b)(4)(iii) provides a rule intended to prevent taxpayers from avoiding the dividend recapture rule of §1.865–2(b)(1) or from accelerating foreign source income and recognizing an offsetting U.S. loss. This rule is substan

February 1, 1999 16 1999–5 I.R.B.

tially the same as the matching rule of §1.865–1T(c)(6)(iii). The rule is promulgated as a temporary regulation because it is necessary to prevent abuse of the residence-based general allocation rule.

Section 1.904–4(c): Grouping Rules

The high-tax kick-out grouping rules of §1.904–4(c) provide rules for determining when particular groups of passive income are high-taxed and, therefore, treated as general limitation income under sections 904(d)(2)(A)(iii)(III) and 904(d)(2)(F). As described above, the proposed amendments to these rules that were proposed in 1992 are finalized as proposed, but taxpayers are afforded some flexibility with respect to the effective date. The amendments were proposed to be effective for taxable years beginning after December 31, 1991. The final regulations are effective for taxable years ending on or after December 31, 1998, but taxpayers may apply the amended regulations to any taxable year beginning after December 31, 1991 and all subsequent years. An example is also added to clarify that foreign taxes that are not creditable (e.g., under section 901(k)) are not withholding taxes for purposes of the grouping rules.

The proposed amendments to the grouping rules that were proposed in 1996 are finalized with two clarifications. Proposed §1.904–4(c)(2)(ii)(B) provides guidance where deductions allocated to a group of passive income exceed the income in that group (i.e., a loss group). A question has been raised as to the proper treatment of foreign taxes in a group that has no taxable income or loss (either because the deductions allocated to the group exactly equal the income in the group or because the foreign taxes assigned to the group are imposed on U.S. source income or income that is not currently taken into account under U.S. tax principles). Consistent with the approach taken in the proposed regulations with respect to loss groups, the final regulations clarify that foreign taxes allocated to a group with no foreign source income are “kicked out” and treated as related to general limitation income.

Proposed §1.904–4(c)(2)(ii)(A) provides that foreign tax imposed on sales that result in loss for U.S. tax purposes is allocated to the group of passive income to which the loss is allocated. While this

correctly states the result where loss on the disposition of property is allocated to passive income under a reciprocal-to-gain rule, under the temporary and final regulations loss may be allocated to reduce the group of passive income where income from the property was assigned (for example, dividends or interest under the anti-abuse rules or the accrued-but-unpaid interest rule) or a separate category of income other than passive income. Accordingly, §1.904–4(c)(2)(ii)(A) of the final regulations is clarified to state that foreign tax imposed on a loss sale is allocated to the group of passive income to which a gain would have been assigned. The examples in §1.904–4(c)(8) of the final regulations are modified to reflect the fact that the consistency rule of §1.865– 2(b)(2) of the proposed regulations has been deleted.

One commentator inquired whether the rule of §1.904–4(c)(2)(ii)(A) allocating foreign tax on a loss sale to a group of passive income is consistent with the tax allocation rule of §1.904–6(a)(1)(iv). The latter rule provides that a foreign tax imposed on an item of income that does not constitute income under U.S. tax principles (a base difference) shall be treated as imposed with respect to general limitation income, whereas a foreign tax imposed on an item that would be income under U.S. tax principles in another year (a timing difference) will be allocated to the appropriate separate category as if the U.S. recognized the income in the same year. Treasury and the Service believe that a base difference exists within the meaning of §1.904–6(a)(1)(iv) only when a foreign country taxes items that the United States would never treat as taxable income, for example, gifts or life insurance proceeds. A sale that results in gain under foreign law but in loss for U.S. tax purposes is attributable to differences in basis calculations rather than to a difference in the concept of taxable income and, therefore, does not constitute a base difference. The tax allocation rule of §1.904–4(c)(2)(ii)(A), allocating foreign taxes on a loss sale to the same group of passive income to which gain would have been assigned had the United States recognized gain on the sale, is conceptually consistent with the treatment of timing differences in §1.904–6(a)(1)(iv).

Effect on Other Documents

The following document is obsolete as of January 11, 1999:

Notice 89–58, 1989–1 C.B. 699.

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.

This Treasury Decision finalizes notices of proposed rulemaking published May 14, 1992 (57 F.R. 20660) and July 8, 1996 (61 F.R. 35696). It has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to the final regulations issued pursuant to the notice of proposed rulemaking published on May 14, 1992. Furthermore, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply to those regulations, because the notice of proposed rulemaking was issued prior to March 29, 1996.

It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to the portion of the notice of proposed rulemaking published on July 8, 1996, relating to section 904 of the Internal Revenue Code. 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.

A final regulatory flexibility analysis under 5 U.S.C. § 604 has been prepared for the final regulations portion of this Treasury Decision with respect to the regulations issued under section 865 of the Internal Revenue Code. A summary of the analysis is set forth below under the heading ‘Summary of Regulatory Flexibility Analysis.’ Because no preceding notice of proposed rulemaking is required for the temporary regulations portion of this Treasury Decision relating to sections 861 and 865 of the Code, the provisions of the Regulatory Flexibility Act do not apply. However, an initial Regulatory Flexibility Analysis was prepared for the proposed regulations published elsewhere in this issue of the Federal Register.

Pursuant to section 7805(f) of the Internal Revenue Code, the notices of proposed rulemaking preceding these regulations were submitted to the Small

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(a) General rules for allocation of loss —(1) Allocation against gain. Except as otherwise provided in §§1.865–2 and 1.865–2T and paragraph (c) of this section, loss recognized with respect to personal property shall be allocated to the class of gross income and, if necessary, apportioned between the statutory grouping of gross income (or among the statutory groupings) and the residual grouping of gross income, with respect to which gain from a sale of such property would give rise in the hands of the seller. Thus, for example, loss recognized by a United States resident on the sale of a bond generally is allocated to reduce United States source income.

(2) Loss attributable to foreign office. Except as otherwise provided in §§1.865– 2 and 1.865–2T and paragraph (c) of this section, and except with respect to loss subject to paragraph (b) of this section, in the case of loss recognized by a United States resident with respect to property that is attributable to an office or other fixed place of business in a foreign country within the meaning of section 865(e)(3), the loss shall be allocated to reduce foreign source income if a gain on the sale of the property would have been taxable by the foreign country and the highest marginal rate of tax imposed on such gains in the foreign country is at least 10 percent. However, paragraph (a)(1) of this section and not this paragraph (a)(2) will apply if gain on the sale of such property would be sourced under section 865(c), (d)(1)(B), or (d)(3).

(3) Loss recognized by United States citizen or resident alien with foreign tax home. Except as otherwise provided in §§1.865–2 and 1.865–2T and paragraph (c) of this section, and except with respect to loss subject to paragraph (b) of this section, in the case of loss with respect to property recognized by a United States citizen or resident alien that has a tax home (as defined in section 911(d)(3)) in a foreign country, the loss shall be allocated to reduce foreign source income if a gain on the sale of such property would have been taxable by a foreign country and the highest marginal rate of tax imposed on such gains in the foreign country is at least 10 percent.

(4) Allocation for purposes of section 904. For purposes of section 904, loss recognized with respect to property that is

Business Administration for comment on their impact on small business.

Summary of Regulatory Flexibility Analysis

It has been determined that a final regulatory flexibility analysis is required under 5 U.S.C. § 604 with respect to the final regulations portion of this Treasury Decision with respect to the regulations issued under section 865 of the Internal Revenue Code. These regulations will affect small entities such as small businesses but not other small entities, such as local government or tax exempt organizations, which do not pay taxes. The IRS and Treasury Department are not aware of any federal rules that duplicate, overlap or conflict with these regulations. The final regulations address the allocation of loss with respect to stock. These regulations are necessary primarily for the proper computation of the foreign tax credit limitation under section 904 of the Internal Revenue Code. With respect to U.S. resident taxpayers, the regulations generally allocate losses against U.S. source income. Generally, this allocation simplifies the computation of the foreign tax credit limitation. None of the significant alternatives considered in drafting the regulations would have significantly altered the economic impact of the regulations on small entities. There are no alternative rules that are less burdensome to small entities but that accomplish the purposes of the statute.

Drafting Information

The principal author of these regulations is Seth B. Goldstein, of the Office of the Associate Chief Counsel (International), 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 is amended by adding entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.865–1T also issued under 26 U.S.C. 865(j)(1). Section 1.865–2 also issued under 26 U.S.C. 865(j)(1). Section 1.865–2T also issued under 26 U.S.C. 865(j)(1). * * *

Par. 2. Section 1.861–8 is amended by adding paragraph (e)(7)(iii) and revising paragraph (e)(8) to read as follows:

§1.861–8 Computation of taxable income from sources within the United States and from other sources and activities.

(e) * * * (7) * * * (iii) Allocation of loss recognized in taxable years after 1986. See §§1.865– 1T, 1.865–2, and 1.865–2T for rules regarding the allocation of certain loss recognized in taxable years beginning after December 31, 1986.

(8) Net operating loss deduction. [Reserved.] For guidance, see §1.861– 8T(e)(8).

Par. 3. Section 1.861–8T is amended by adding paragraph (e)(8) and a sentence at the end of paragraph (h) to read as follows:

§1.861–8T Computation of taxable income from sources within the United States and from other sources and activities (Temporary).

(e) * * * (8) Net operating loss deduction . A net operating loss deduction allowed under section 172 shall be allocated and apportioned in the same manner as the deductions giving rise to the net operating loss deduction.

(h) * * * Paragraph (e)(8) of this section shall cease to be effective January 8, 2002. Par. 4. Section 1.865–1T is added immediately following §1.864–8T, to read as follows:

§1.865–1T Loss with respect to personal property other than stock (Temporary).

February 1, 1999 18 1999–5 I.R.B.

tion is to change the allocation of a builtin loss on the disposition of personal property by converting the original property into other property and subsequently recognizing loss with respect to such other property, the loss shall be allocated as if it were recognized with respect to the original property immediately prior to the transaction. Transactions subject to this paragraph shall include, without limitation, reorganizations within the meaning of section 368(a), liquidations under section 332, transfers to a corporation under section 351, transfers to a partnership under section 721, transfers to a trust, distributions by a partnership, distributions by a trust, transfers to or from a qualified business unit, office or other fixed place of business, or branch, or exchanges under section 1031. A person may have a principal purpose of affecting loss allocation even though this purpose is outweighed by other purposes (taken together or separately).

(ii) Offsetting positions. If a taxpayer recognizes loss with respect to personal property and the taxpayer (or any person described in section 267(b) (after application of section 267(c)), 267(e), 318 or 482 with respect to the taxpayer) holds (or held) offsetting positions with respect to such property with a principal purpose of recognizing foreign source income and United States source loss, the loss shall be allocated and apportioned against such foreign source income. For purposes of this paragraph (c)(6)(ii), positions are offsetting if the risk of loss of holding one or more positions is substantially diminished by holding one or more other positions.

(iii) Matching rule. To the extent a taxpayer (or a person described in section 1059(c)(3)(C) with respect to the taxpayer) recognizes foreign source income for tax purposes that results in the creation of a corresponding loss with respect to personal property, the loss shall be allocated and apportioned against such income. For examples illustrating a similar rule with respect to stock loss, see Examples 3 through 6 of §1.865–2T(b)(4)(iv).

(d) Definitions —(1) Contingent pay- ment debt instrument. A contingent payment debt instrument is any debt instrument that is subject to §1.1275–4.

(2) Depreciable personal property. Depreciable personal property is any property described in section 865(c)(4)(A).

allocated to foreign source income under this paragraph (a) shall be allocated to the separate category under section 904(d) to which gain on the sale of the property would have been assigned (without regard to section 904(d)(2)(A)(iii)(III)). For purposes of §1.904–4(c)(2)(ii)(A), any such loss allocated to passive income shall be allocated (prior to the application of §1.904–4(c)(2)(ii)(B)) to the group of passive income to which gain on a sale of the property would have been assigned had a sale of the property resulted in the recognition of a gain under the law of the relevant foreign jurisdiction or jurisdictions.

(5) Loss recognized by partnership. A partner’s distributive share of loss recognized by a partnership with respect to personal property shall be allocated and apportioned in accordance with this section as if the partner had recognized the loss. If loss is attributable to an office or other fixed place of business of the partnership within the meaning of section 865(e)(3), such office or fixed place of business shall be considered to be an office of the partner for purposes of this section.

(b) Special rules of application —(1) Depreciable property. In the case of a loss recognized with respect to depreciable personal property, the gain referred to in paragraph (a)(1) of this section is the gain that would be sourced under section 865(c)(1) (depreciation recapture). (2) Contingent payment debt instru- ment. Except to the extent provided in §1.1275–4(b)(9)(iv), loss recognized with respect to a contingent payment debt instrument to which §1.1275–4(b) applies (instruments issued for money or publicly traded property) shall be allocated to the class of gross income and, if necessary, apportioned between the statutory grouping of gross income (or among the statutory groupings) and the residual grouping of gross income, with respect to which interest income from the instrument (in the amount of the loss subject to this paragraph (b)(2)) would give rise.

(c) Exceptions —(1) Foreign currency and certain financial instruments. This section does not apply to loss governed by section 988 and loss recognized with respect to options contracts or derivative financial instruments, including futures contracts, forward contracts, notional principal contracts, or evidence of an interest in any of the foregoing.

(2) Inventory. This section does not apply to loss recognized with respect to property described in section 1221(1).

(3) Interest equivalents and trade re- ceivables. Loss subject to §1.861–9T(b) (loss equivalent to interest expense and loss on trade receivables) shall be allocated and apportioned under the rules of §1.861–9T and not under the rules of this section.

(4) Unamortized bond premium. To the extent a taxpayer recognizing loss with respect to a bond (within the meaning of §1.171–1(b)) did not amortize bond premium to the full extent permitted by §§1.171–2 or 1.171–3 (or §1.171–1, as contained in the 26 CFR part 1 edition revised as of April 1, 1997)(as applicable), loss recognized with respect to the bond shall be allocated to the class of gross income and, if necessary, apportioned between the statutory grouping of gross income (or among the statutory groupings) and the residual grouping of gross income, with respect to which interest income from the bond was assigned.

(5) Accrued interest. Loss attributable to accrued but unpaid interest on a debt obligation shall be allocated to the class of gross income and, if necessary, apportioned between the statutory grouping of gross income (or among the statutory groupings) and the residual grouping of gross income, with respect to which interest income from the obligation was assigned. For purposes of this section, whether loss is attributable to accrued but unpaid interest (rather than to principal) shall be determined under the principles of §§1.61–7(d) and 1.446–2(e).

(6) Anti-abuse rules —(i) Transactions involving built-in losses. If one of the principal purposes of a transaction is to change the allocation of a built-in loss with respect to personal property by transferring the property to another person, qualified business unit, office or other fixed place of business, or branch that subsequently recognizes the loss, the loss shall be allocated by the transferee as if it were recognized by the transferor immediately prior to the transaction. If one of the principal purposes of a change of residence is to change the allocation of a built-in loss with respect to personal property, the loss shall be allocated as if the change of residence had not occurred. If one of the principal purposes of a transac

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(3) Terms defined in §1.861–8. See §1.861–8 for the meaning of class of gross income, statutory grouping of gross income, and residual grouping of gross income.

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

Example 1. On January 1, 1997, A, a domestic corporation, purchases for $1,000 a machine that produces widgets, which A sells in the United States and throughout the world. Throughout A ’s holding period, the machine is located and used in Country X. During A ’s holding period, A incurs depreciation deductions of $400 with respect to the machine. Under §1.861–8, A allocates and apportions depreciation deductions of $250 against foreign source general limitation income and $150 against U.S. source income. On December 12, 1999, A sells the machine and recognizes a loss of $500. Because the machine was used predominantly outside the United States, under section 865(c)(1)(B) and (c)(3)(B)(ii), gain on the disposition of the machine would be foreign source general limitation income to the extent of the depreciation adjustments. Therefore, under paragraph (b)(1) of this section, the entire $500 loss is allocated against foreign source general limitation income.

Example 2. On January 1, 1997, A, a domestic corporation, loans $2,000 to N, its wholly-owned controlled foreign corporation, in exchange for a contingent payment debt instrument subject to §1.1275–4(b). During 1997 through 1999, A accrues and receives interest income of $630, $150 of which is foreign source general limitation income and $480 of which is foreign source passive income under section 904(d)(3). Assume there are no positive or negative adjustments pursuant to §1.1275– 4(b)(6) in 1997 through 1999. On January 1, 2000, A disposes of the debt instrument and recognizes a $770 loss. Under §1.1275–4(b)(8)(ii), $630 of the loss is treated as ordinary loss and $140 is treated as capital loss. Assume that $140 of interest income earned in 2000 with respect to the debt instrument would be foreign source passive income under section 904(d)(3). Under §1.1275–4(b)(9)(iv), $150 of the ordinary loss is allocated against foreign source general limitation income and $480 of the ordinary loss is allocated against foreign source passive income. Under paragraph (b)(2) of this section, the $140 capital loss is allocated against foreign source passive income.

Example 3. On January 1, 1997, A, a domestic corporation, purchases for $1,000 a bond maturing January 1, 2009, with a stated principal amount of $1,000, payable at maturity. The bond provides for unconditional payments of interest of $100, payable December 31 of each year. The issuer of the bond is a foreign corporation and interest on the bond is thus foreign source. Between 1997 and 2001, A accrues and receives foreign source interest income of $500 with respect to the bond. On January 1, 2002, A sells the bond and recognizes a $500 loss. Under paragraph (a)(1) of this section, the $500 loss is allocated against U.S. source income. Paragraph (c)(6)(iii) of this section is not applicable because A’s recognition of the foreign source income did not

result in the creation of a corresponding loss with respect to the bond.

Example 4. On January 1, 1999, A, a domestic corporation on the accrual method of accounting, purchases for $1,000 a bond maturing January 1, 2009, with a stated principal amount of $1,000, payable at maturity. The bond provides for unconditional payments of interest of $100, payable December 31 of each year. The issuer of the bond is a foreign corporation and interest on the bond is thus foreign source. On June 10, 1999, after A has accrued $44 of interest income, but before any interest has been paid, the issuer suddenly becomes insolvent and declares bankruptcy. A sells the bond (including the accrued interest) for $20. Assuming that A properly accrued $44 interest income, A treats the $20 proceeds from the sale of the bond as payment of interest previously accrued and recognizes a $1000 loss with respect to the bond principal and a $24 loss with respect to the accrued interest. See §1.61–7(d). Under paragraph (a)(1) of this section, the $1000 loss with respect to the principal is allocated against U.S. source income. Under paragraph (c)(5) of this section, the $24 loss with respect to accrued but unpaid interest is allocated against foreign source interest income.

(f) Effective date —(1) In general. Except as provided in paragraph (f)(2) of this section, this section is effective for loss recognized on or after January 11, 1999. For purposes of this paragraph (f), loss that is recognized but deferred (for example, under section 267 or 1092) shall be treated as recognized at the time the loss is taken into account. This section shall cease to be effective January 8, 2002.

(2) Application to prior periods. A taxpayer may apply the rules of this section to losses recognized in any taxable year beginning on or after January 1, 1987, and all subsequent years, provided that—

(i) The taxpayer’s tax liability as shown on an original or amended tax return is consistent with the rules of this section for each such year for which the statute of limitations does not preclude the filing of an amended return on June 30, 1999; and

(ii) The taxpayer makes appropriate adjustments to eliminate any double benefit arising from the application of this section to years that are not open for assessment.

(3) Examples. See §1.865–2(e)(3) for examples illustrating an effective date provision similar to the effective date provided in this paragraph (f).

Par. 5. Section 1.865–2 is added immediately after §1.865–1T, to read as follows:

§1.865–2 Loss with respect to stock.

(a) General rules for allocation of loss with respect to stock —(1) Allocation

against gain. Except as otherwise provided in paragraph (b) of this section, loss recognized with respect to stock shall be allocated to the class of gross income and, if necessary, apportioned between the statutory grouping of gross income (or among the statutory groupings) and the residual grouping of gross income, with respect to which gain (other than gain treated as a dividend under section 964(e)(1) or 1248) from a sale of such stock would give rise in the hands of the seller (without regard to section 865(f)). Thus, for example, loss recognized by a United States resident on the sale of stock generally is allocated to reduce United States source income.

(2) Stock attributable to foreign office. Except as otherwise provided in paragraph (b) of this section, in the case of loss recognized by a United States resident with respect to stock that is attributable to an office or other fixed place of business in a foreign country within the meaning of section 865(e)(3), the loss shall be allocated to reduce foreign source income if a gain on the sale of the stock would have been taxable by the foreign country and the highest marginal rate of tax imposed on such gains in the foreign country is at least 10 percent.

(3) Loss recognized by United States citizen or resident alien with foreign tax home —(i) In general. Except as otherwise provided in paragraph (b) of this section, in the case of loss with respect to stock that is recognized by a United States citizen or resident alien that has a tax home (as defined in section 911(d)(3)) in a foreign country, the loss shall be allocated to reduce foreign source income if a gain on the sale of the stock would have been taxable by a foreign country and the highest marginal rate of tax imposed on such gains in the foreign country is at least 10 percent.

(ii) Bona fide residents of Puerto Rico. Except as otherwise provided in paragraph (b) of this section, in the case of loss with respect to stock in a corporation described in section 865(g)(3) recognized by a United States citizen or resident alien that is a bona fide resident of Puerto Rico during the entire taxable year, the loss shall be allocated to reduce foreign source income.

(4) Stock constituting a United States real property interest. Loss recognized

February 1, 1999 20 1999–5 I.R.B.

by a nonresident alien individual or a foreign corporation with respect to stock that constitutes a United States real property interest shall be allocated to reduce United States source income. For additional rules governing the treatment of such loss, see section 897 and the regulations thereunder.

(5) Allocation for purposes of section 904. For purposes of section 904, loss recognized with respect to stock that is allocated to foreign source income under this paragraph (a) shall be allocated to the separate category under section 904(d) to which gain on a sale of the stock would have been assigned (without regard to section 904(d)(2)(A)(iii)(III)). For purposes of §1.904–4(c)(2)(ii)(A), any such loss allocated to passive income shall be allocated (prior to the application of §1.904–4(c)(2)(ii)(B)) to the group of passive income to which gain on a sale of the stock would have been assigned had a sale of the stock resulted in the recognition of a gain under the law of the relevant foreign jurisdiction or jurisdictions.

(b) Exceptions —(1) Dividend recap- ture exception —(i) In general. If a taxpayer recognizes a loss with respect to shares of stock, and the taxpayer (or a person described in section 1059(c)(3)(C) with respect to such shares) included in income a dividend recapture amount (or amounts) with respect to such shares at any time during the recapture period, then, to the extent of the dividend recapture amount (or amounts), the loss shall be allocated and apportioned on a proportionate basis to the class or classes of gross income or the statutory or residual grouping or groupings of gross income to which the dividend recapture amount was assigned.

(ii) Exception for de minimis amounts. Paragraph (b)(1)(i) of this section shall not apply to a loss recognized by a taxpayer on the disposition of stock if the sum of all dividend recapture amounts (other than dividend recapture amounts eligible for the exception described in paragraph (b)(1)(iii) of this section (passive limitation dividends)) included in income by the taxpayer (or a person described in section 1059(c)(3)(C)) with respect to such stock during the recapture period is less than 10 percent of the recognized loss.

(iii) Exception for passive limitation dividends. Paragraph (b)(1)(i) of this section shall not apply to the extent of a dividend recapture amount that is treated as income in the separate category for passive income described in section 904(d)(2)(A) (without regard to section 904(d)(2)(A)(iii)(III)). The exception provided for in this paragraph (b)(1)(iii) shall not apply to any dividend recapture amount that is treated as income in the separate category for financial services income described in section 904(d)(2)(C).

(iv) Examples. The application of this paragraph (b)(1) may be illustrated by the following examples:

Example 1. (i) P, a domestic corporation, is a United States shareholder of N, a controlled foreign corporation. N has never had any subpart F income and all of its earnings and profits are described in section 959(c)(3). On May 5, 1998, N distributes a dividend to P in the amount of $100. The dividend gives rise to a $5 foreign withholding tax, and P is deemed to have paid an additional $45 of foreign income tax with respect to the dividend under section 902. Under the look-through rules of section 904(d)(3) the dividend is general limitation income described in section 904(d)(1)(I).

(ii) On February 6, 2000, P sells its shares of N and recognizes a $110 loss. In 2000, P has the following taxable income, excluding the loss on the sale of N :

(A) $1,000 of foreign source income that is general limitation income described in section 904(d)(1)(I); (B) $1,000 of foreign source capital gain from the sale of stock in a foreign affiliate that is sourced under section 865(f) and is passive income described in section 904(d)(1)(A); and

(C) $1,000 of U.S. source income. (iii) The $100 dividend paid in 1998 is a dividend recapture amount that was included in P ’s income within the recapture period preceding the disposition of the N stock. The de minimis exception of paragraph (b)(1)(ii) of this section does not apply because the $100 dividend recapture amount exceeds 10 percent of the $110 loss. Therefore, to the extent of the $100 dividend recapture amount, the loss must be allocated under paragraph (b)(1)(i) of this section to the separate limitation category to which the dividend was assigned (general limitation income).

(iv) P ’s remaining $10 loss on the disposition of the N stock is allocated to U.S. source income under paragraph (a)(1) of this section.

(v) After allocation of the stock loss, P’s foreign source taxable income in 2000 consists of $900 of foreign source general limitation income and $1,000 of foreign source passive income.

Example 2. (i) P, a domestic corporation, owns all of the stock of N1, which owns all of the stock of N2, which owns all of the stock of N3. N1, N2, and N3 are controlled foreign corporations. All of the corporations use the calendar year as their taxable year. On February 5, 1997, N3 distributes a divi

dend to N2 . The dividend is foreign personal holding company income of N2 under section 954(c)(1)(A) that results in an inclusion of $100 in P ’s income under section 951(a)(1)(A)(i) as of December 31, 1997. Under section 904(d)(3)(B) the inclusion is general limitation income described in section 904(d)(1)(I). The income inclusion to P results in a corresponding increase in P ’s basis in the stock of N1 under section 961(a).

(ii) On March 5, 1999, P sells its shares of N1 and recognizes a $110 loss. The $100 1997 subpart F inclusion is a dividend recapture amount that was included in P ’s income within the recapture period preceding the disposition of the N1 stock. The de minimis exception of paragraph (b)(1)(ii) of this section does not apply because the $100 dividend recapture amount exceeds 10 percent of the $110 loss. Therefore, to the extent of the $100 dividend recapture amount, the loss must be allocated under paragraph (b)(1)(i) of this section to the separate limitation category to which the dividend recapture amount was assigned (general limitation income). The remaining $10 loss is allocated to U.S. source income under paragraph (a)(1) of this section.

Example 3. (i) P, a domestic corporation, owns all of the stock of N1, which owns all of the stock of N2. N1 and N2 are controlled foreign corporations. All the corporations use the calendar year as their taxable year and the U.S. dollar as their functional currency. On May 5, 1998, N2 pays a dividend of $100 to N1 out of general limitation earnings and profits.

(ii) On February 5, 2000, N1 sells its N2 stock to an unrelated purchaser. The sale results in a loss to N1 of $110 for U.S. tax purposes. In 2000, N1 has the following current earnings and profits, excluding the loss on the sale of N2:

(A) $1,000 of non-subpart F foreign source general limitation earnings and profits described in section 904(d)(1)(I);

(B) $1,000 of foreign source gain from the sale of stock that is taken into account in determining foreign personal holding company income under section 954(c)(1)(B)(i) and which is passive limitation earnings and profits described in section 904(d)(1)(A); (C) $1,000 of foreign source interest income received from an unrelated person that is foreign personal holding company income under section 954(c)(1)(A) and which is passive limitation earnings and profits described in section 904(d)(1)(A).

(iii) The $100 dividend paid in 1998 is a dividend recapture amount that was included in N1 ’s income within the recapture period preceding the disposition of the N2 stock. The de minimis exception of paragraph (b)(1)(ii) of this section does not apply because the $100 dividend recapture amount exceeds 10 percent of the $110 loss. Therefore, to the extent of the $100 dividend recapture amount, the loss must be allocated under paragraph (b)(1)(i) of this section to the separate limitation category to which the dividend was assigned (general limitation earnings and profits).

(iv) N1 ’s remaining $10 loss on the disposition of the N2 stock is allocated to foreign source passive limitation earnings and profits under paragraph (a)(1) of this section.

(v) After allocation of the stock loss, N1 ’s current earnings and profits for 1998 consist of $900 of for

1999–5 I.R.B 21 February 1, 1999

eign source general limitation earnings and profits and $1,990 of foreign source passive limitation earnings and profits.

(vi) After allocation of the stock loss, N1 ’s subpart F income for 2000 consists of $1,000 of foreign source interest income that is foreign personal holding company income under section 954(c)(1)(A) and $890 of foreign source net gain that is foreign personal holding company income under section 954(c)(1)(B)(i). P includes $1,890 in income under section 951(a)(1)(A)(i) as passive income under sections 904(d)(1)(A) and 904(d)(3)(B).

Example 4. P, a foreign corporation, has two wholly-owned subsidiaries, S, a domestic corporation, and B, a foreign corporation. On January 1, 2000, S purchases a one-percent interest in N, a foreign corporation, for $100. On January 2, 2000, N distributes a $20 dividend to S . The $20 dividend is foreign source financial services income. On January 3, 2000, S sells its N stock to B for $80 and recognizes a $20 loss that is deferred under section 267(f). On June 10, 2008, B sells its N stock to an unrelated person for $55. Under section 267(f) and §1.267(f)–1(c)(1), S ’s $20 loss is deferred until 2008. Under this paragraph (b)(1), the $20 loss is allocated to reduce foreign source financial services income in 2008 because the loss was recognized (albeit deferred) within the 24-month recapture period following the receipt of the dividend. See §§1.267(f)–1(a)(2)(i)(B) and 1.267(f)–1(c)(2).

Example 5. The facts are the same as in Example 4, except P, S, and B are domestic corporations and members of the P consolidated group. Under the matching rule of §1.1502–13(c)(1), the separate entity attributes of S ’s intercompany items and B ’s corresponding items are redetermined to the extent necessary to produce the same effect on consolidated taxable income as if S and B were divisions of a single corporation and the intercompany transaction was a transaction between divisions. If S and B were divisions of a single corporation, the transfer of N stock on January 3, 2000 would be ignored for tax purposes, and the corporation would be treated as selling that stock only in 2008. Thus, the corporation’s entire $45 loss would have been allocated against U.S. source income under paragraph (a)(1) of this section because a dividend recapture amount was not received during the corporation’s recapture period. Accordingly, S ’s $20 loss and B ’s $25 loss are allocated to reduce U.S. source income.

(2) Exception for inventory. This section does not apply to loss recognized with respect to stock described in section 1221(1). (3) Exception for stock in an S corpora- tion. This section does not apply to loss recognized with respect to stock in an S corporation (as defined in section 1361).

(4) Anti-abuse rules —(i) Transactions involving built-in losses. If one of the principal purposes of a transaction is to change the allocation of a built-in loss with respect to stock by transferring the stock to another person, qualified business unit (within the meaning of section 989(a)), office or other fixed place of

business, or branch that subsequently recognizes the loss, the loss shall be allocated by the transferee as if it were recognized with respect to the stock by the transferor immediately prior to the transaction. If one of the principal purposes of a change of residence is to change the allocation of a built-in loss with respect to stock, the loss shall be allocated as if the change of residence had not occurred. If one of the principal purposes of a transaction is to change the allocation of a builtin loss with respect to stock (or other personal property) by converting the original property into other property and subsequently recognizing loss with respect to such other property, the loss shall be allocated as if it were recognized with respect to the original property immediately prior to the transaction. Transactions subject to this paragraph shall include, without limitation, reorganizations within the meaning of section 368(a), liquidations under section 332, transfers to a corporation under section 351, transfers to a partnership under section 721, transfers to a trust, distributions by a partnership, distributions by a trust, or transfers to or from a qualified business unit, office or other fixed place of business. A person may have a principal purpose of affecting loss allocation even though this purpose is outweighed by other purposes (taken together or separately).

(ii) Offsetting positions. If a taxpayer recognizes loss with respect to stock and the taxpayer (or any person described in section 267(b) (after application of section 267(c)), 267(e), 318 or 482 with respect to the taxpayer) holds (or held) offsetting positions with respect to such stock with a principal purpose of recognizing foreign source income and United States source loss, the loss will be allocated and apportioned against such foreign source income. For purposes of this paragraph (b)(4)(ii), positions are offsetting if the risk of loss of holding one or more positions is substantially diminished by holding one or more other positions.

(iii) Matching rule. [Reserved] For further guidance, see §1.865–2T(b)(4)(iii).

(iv) Examples. The application of this paragraph (b)(4) may be illustrated by the following examples. No inference is intended regarding the application of any other Internal Revenue Code section or judicial doctrine that may apply to disal

low or defer the recognition of loss. The examples are as follows:

Example 1 . (i) Facts. On January 1, 2000, P, a domestic corporation, owns all of the stock of N1, a controlled foreign corporation, which owns all of the stock of N2, a controlled foreign corporation. N1 ’s basis in the stock of N2 exceeds its fair market value, and any loss recognized by N1 on the sale of N2 would be allocated under paragraph (a)(1) of this section to reduce foreign source passive limitation earnings and profits of N1 . In contemplation of the sale of N2 to an unrelated purchaser, P causes N1 to liquidate with principal purposes of recognizing the loss on the N2 stock and allocating the loss against U.S. source income. P sells the N2 stock and P recognizes a loss.

(ii) Loss allocation. Because one of the principal purposes of the liquidation was to transfer the stock to P in order to change the allocation of the built-in loss on the N2 stock, under paragraph (b)(4)(i) of this section the loss is allocated against P ’s foreign source passive limitation income.

Example 2. (i) Facts. On January 1, 2000, P, a domestic corporation, forms N and F, foreign corporations, and contributes $1,000 to the capital of each. N and F enter into offsetting positions in financial instruments that produce financial services income. Holding the N stock substantially diminishes P ’s risk of loss with respect to the F stock (and vice versa). P holds N and F with a principal purpose of recognizing foreign source income and U.S. source loss. On March 31, 2000, when the financial instrument held by N is worth $1,200 and the financial instrument held by F is worth $800, P sells its F stock and recognizes a $200 loss.

(ii) Loss allocation . Because P held an offsetting position with respect to the F stock with a principal purpose of recognizing foreign source income and U.S. source loss, the $200 loss is allocated against foreign source financial services income under paragraph (b)(4)(ii) of this section.

(c) Loss recognized by partnership. A partner’s distributive share of loss recognized by a partnership shall be allocated and apportioned in accordance with this section as if the partner had recognized the loss. If loss is attributable to an office or other fixed place of business of the partnership within the meaning of section 865(e)(3), such office or fixed place of business shall be considered to be an office of the partner for purposes of this section.

(d) Definitions —(1) Terms defined in §1.861–8. See §1.861–8 for the meaning of class of gross income, statutory group- ing of gross income, and residual group- ing of gross income.

(2) Dividend recapture amount. A dividend recapture amount is a dividend (except for an amount treated as a dividend under section 78), an inclusion described in section 951(a)(1)(A)(i) (but only to the

February 1, 1999 22 1999–5 I.R.B.

extent attributable to a dividend (including a dividend under section 964(e)(1)) included in the earnings of a controlled foreign corporation (held directly or indirectly by the person recognizing the loss) that is included in foreign personal holding company income under section 954(c)(1)(A)) and an inclusion described in section 951(a)(1)(B).

(3) Recapture period. A recapture period is the 24-month period preceding the date on which a taxpayer recognizes a loss with respect to stock, increased by any period of time in which the taxpayer has diminished its risk of loss in a manner described in section 246(c)(4) and the regulations thereunder and by any period in which the assets of the corporation are hedged against risk of loss with a principal purpose of enabling the taxpayer to hold the stock without significant risk of loss until the recapture period has expired.

(4) United States resident. See section 865(g) and the regulations thereunder for the definition of United States resident.

(e) Effective date —(1) In general. This section is effective for loss recognized on or after January 11, 1999. For purposes of this paragraph (e), loss that is recognized but deferred (for example, under section 267 or 1092) shall be treated as recognized at the time the loss is taken into account.

(i) The taxpayer’s tax liability as shown on an original or amended tax return is consistent with the rules of this section and §1.865–2T for each such year for which the statute of limitations does not preclude the filing of an amended return on June 30, 1999; and

(ii) The taxpayer makes appropriate adjustments to eliminate any double benefit arising from the application of this section to years that are not open for assessment.

(3) Examples. The rules of this paragraph (e) may be illustrated by the following examples:

Example 1. (i) P, a domestic corporation, has a calendar taxable year. On March 10, 1985, P recognizes a $100 capital loss on the sale of N, a foreign corporation. Pursuant to sections 1211(a) and 1212(a), the loss is not allowed in 1985 and is carried over to the 1990 taxable year. The loss is allo

cated against foreign source income under §1.861– 8(e)(7). In 1999, P chooses to apply this section to all losses recognized in its 1987 taxable year and in all subsequent years.

(ii) Allocation of the loss on the sale of N is not affected by the rules of this section because the loss was recognized in a taxable year that did not begin after December 31, 1986.

Example 2. (i) P, a domestic corporation, has a calendar taxable year. On March 10, 1988, P recognizes a $100 capital loss on the sale of N, a foreign corporation. Pursuant to sections 1211(a) and 1212(a), the loss is not allowed in 1988 and is carried back to the 1985 taxable year. The loss is allocated against foreign source income under §1.861– 8(e)(7) on P ’s federal income tax return for 1985 and increases an overall foreign loss account under §1.904(f)–1.

(ii) In 1999, P chooses to apply this section to all losses recognized in its 1987 taxable year and in all subsequent years. Consequently, the loss on the sale of N is allocated against U.S. source income under paragraph (a)(1) of this section. Allocation of the loss against U.S. source income reduces P ’s overall foreign loss account and increases P ’s tax liability in 2 years: 1990, a year that will not be open for assessment on June 30, 1999, and 1997, a year that will be open for assessment on June 30, 1999. Pursuant to paragraph (e)(2)(i) of this section, P must file an amended federal income tax return that reflects the rules of this section for 1997, but not for 1990.

Example 3. (i) P, a domestic corporation, has a calendar taxable year. On March 10, 1989, P recognizes a $100 capital loss on the sale of N, a foreign corporation. The loss is allocated against foreign source income under §1.861–8(e)(7) on P ’s federal income tax return for 1989 and results in excess foreign tax credits for that year. The excess credit is carried back to 1988, pursuant to section 904(c). In 1999, P chooses to apply this section to all losses recognized in its 1989 taxable year and in all subsequent years. On June 30, 1999, P ’s 1988 taxable year is closed for assessment, but P ’s 1989 taxable year is open with respect to claims for refund.

(ii) Because P chooses to apply this section to its 1989 taxable year, the loss on the sale of N is allocated against U.S. source income under paragraph (a)(1) of this section. Allocation of the loss against U.S. source income would have permitted the foreign tax credit to be used in 1989, reducing P ’s tax liability in 1989. Nevertheless, under paragraph (e)(2)(ii) of this section, because the credit was carried back to 1988, P may not claim the foreign tax credit in 1989.

Par. 6. Section 1.865–2T is added immediately after §1.865–2, to read as follows:

§1.865–2T Loss with respect to stock (Temporary).

(a) through (b)(4)(ii) [Reserved] For further guidance, see §1.865–2(a) through (b)(4)(ii).

(b)(4)(iii) Matching rule. To the extent a taxpayer (or a person described in section 1059(c)(3)(C) with respect to the tax

payer) recognizes foreign source income for tax purposes that results in the creation of a corresponding loss with respect to stock, the loss shall be allocated and apportioned against such income. This paragraph (b)(4)(iii) shall not apply to the extent a loss is related to a dividend recapture amount and §1.865–2(b)(1)(ii) (de minimis exception) or (b)(1)(iii) (passive dividend exception) exempts the loss from §1.865–2(b)(1)(i) (dividend recapture rule), unless the stock is held with a principal purpose of producing foreign source income and corresponding loss.

Examples 1 and 2. [Reserved] For further guidance, see §1.865–2(b)(4)(iv).

Example 3. (i) Facts. On January 1, 1999, P and Q, domestic corporations, form R, a domestic partnership. The corporations and partnership use the calendar year as their taxable year. P contributes $900 to R in exchange for a 90- percent partnership interest and Q contributes $100 to R in exchange for a 10-percent partnership interest. R purchases a dance studio in country X for $1,000. On January 2, 1999, R enters into contracts to provide dance lessons in Country X for a 5-year period beginning January 1, 2000. These contracts are prepaid by the dance studio customers on December 31, 1999, and R recognizes foreign source taxable income of $500 from the prepayments ( R ’s only income in 1999). P takes into income its $450 distributive share of partnership taxable income. On January 1, 2000, P ’s basis in its partnership interest is $1,350 ($900 from its contribution under section 722, increased by its $450 distributive share of partnership income under section 705). On September 22, 2000, P contributes its R partnership interest to S, a newly-formed domestic corporation, in exchange for all the stock of S. Under section 358, P ’s basis in S is $1,350. On December 1, 2000, P sells S to an unrelated party for $1050 and recognizes a $300 loss.

(ii) Loss allocation. Because P recognized foreign source income for tax purposes that resulted in the creation of a corresponding loss with respect to the S stock, the $300 loss is allocated against foreign source income under paragraph (b)(4)(iii) of this section.

Example 4. (i) Facts. On January 1, 2000, P, a domestic corporation that uses the calendar year as its taxable year forms N, a foreign corporation. P contributes $1,000 to the capital of N in exchange for 100 shares of common stock. P contributes an additional $1,000 to the capital of N in exchange for 100 shares of preferred stock. Each preferred share is entitled to 15- percent dividend but is redeemable by N on or after January 1, 2010, for $1. Prior to

1999–5 I.R.B 23 February 1, 1999

(c) High-taxed income —(1) In general. Income received or accrued by a United States person that would otherwise be passive income shall not be treated as passive income if the income is determined to be high-taxed income. Income shall be considered to be high-taxed income if, after allocating expenses, losses and other deductions of the United States person to that income under paragraph (c)(2)(ii) of this section, the sum of the foreign income taxes paid or accrued by the United States person with respect to such income and the foreign taxes deemed paid or accrued by the United States person with respect to such income under section 902 or section 960 exceeds the highest rate of tax specified in section 1 or 11, whichever applies (and with reference to section 15 if applicable), multiplied by the amount of such income (including the amount treated as a dividend under section 78). If, after application of this paragraph (c), income that would otherwise be passive income is determined to be high-taxed income, such income shall be treated as general limitation income, and any taxes imposed on that income shall be considered related to general limitation income under §1.904–6. If, after application of this paragraph (c), passive income is zero or less than zero, any taxes imposed on the passive income shall be considered related to general limitation income. For additional rules regarding losses related to passive income, see paragraph (c)(2) of this section. Income and taxes shall be translated at the appropriate rates, as determined under sections 986, 987 and 989 and the regulations under those sections, before application of this paragraph (c). For purposes of allocating taxes to groups of income, United States source passive income is treated as any other passive income. In making the determination whether income is high-taxed, however, only foreign source income, as determined under United States tax principles, is relevant. See paragraph (c)(8) Exam- ples 10 through 13 of this section for examples illustrating the application of this paragraph (c)(1) and paragraph (c)(2) of this section.

(2) Grouping of items of income in order to determine whether passive in- come is high-taxed income —(i) Effective dates —(A) In general. For purposes of determining whether passive income is

January 10, 2005, P receives a total of $750 of distributions from N with respect to its preferred shares, which P treats as foreign source general limitation dividends. On January 10, 2005, P sells its 100 preferred shares in N to an unrelated purchaser for $600. Assume that this arrangement is not recharacterized under Notice 97–21 (1997–1 C.B. 407).

(ii) Loss allocation. Because P recognized foreign source income for tax purposes that resulted in the creation of a corresponding loss with respect to the N stock, the $400 loss is allocated against foreign source general limitation income under paragraph (b)(4)(iii) of this section.

Example 5. (i) Facts. On January 1, 2000, P, a domestic corporation that uses the calendar year as its taxable year, and F, a newly-formed controlled foreign corporation wholly-owned by P, form N, a foreign corporation. P contributes $1,000 to the capital of N in exchange for 100 shares of common stock and $1,000 to the capital of F in exchange for 100 shares of common stock. F contributes LC1,000 to the capital of N in exchange for 100 shares of preferred stock. Each preferred share is entitled to a 65-percent LC dividend. At the time of the contributions, $1=LC1. The LC is expected to depreciate significantly in relation to the U.S. dollar. Prior to June 10, 2005, P receives a total of $1,900 of distributions from F, which it treats as foreign source general limitation dividends. On June 10, 2005, the N preferred stock has a fair market value of $25 and P sells F for $25 to an unrelated person. Assume that this arrangement is not recharacterized under Notice 97–21 (1997–1 C.B. 407).

(ii) Loss allocation. Because P recognized foreign source income for tax purposes that resulted in the creation of a corresponding loss with respect to the F stock, the $975 loss is allocated against foreign source general limitation income under paragraph (b)(4)(iii) of this section.

Example 6. (i) Facts. On January 1, 1998, P, a domestic corporation, purchases N, a foreign corporation, for $1000. On March 1, 1998, N sells its operating assets, distributes a $400 general limitation dividend to P, and invests its remaining $600 in short term government securities. N earns interest income from the securities. The income constitutes subpart F income that is included in P ’s income under section 951, increasing P ’s basis in the N stock under section 961(a). On March 1, 2002, P sells N and recognizes a $400 loss.

(ii) Loss allocation. The $400 dividend received by P resulted in a $400 built-in loss in the N stock, which was locked in for P ’s four-year holding period. Because P recognized foreign source income for tax purposes that resulted in the creation of a corresponding loss with respect to the N stock, under paragraph (b)(4)(iii) of this section the $400 loss is allocated against foreign source general limitation income.

(i) The taxpayer’s tax liability as shown on an original or amended tax return is consistent with the rules of this section and §1.865–2 for each such year for which the statute of limitations does not preclude the filing of an amended return on June 30, 1999; and

(ii) The taxpayer makes appropriate adjustments to eliminate any double benefit arising from the application of this section to years that are not open for assessment.

Par. 7. Section 1.904–0 is amended by revising the entry for §1.904–4(c)(2)(i) and (ii) and adding entries for paragraphs (c)(2)(i)(A), (c)(2)(i)(B), (c)(2)(ii)(A) and (c)(2)(ii)(B) to read as follows:

§1.904–0 Outline of regulation provisions for section 904.

§1.904–4 Separate application of section 904 with respect to certain categories of income.

(c) - * * (2) - * * (i) Effective dates. (A) In general. (B) Application to prior periods. (ii) Grouping rules. (A) Initial allocation and apportionment of deductions and taxes. (B) Reallocation of loss groups.

Par. 8. Section 1.904–4 is amended by:

Revising paragraphs (c)(1) and (c)(2),
Revising paragraph (c)(3)(iii),
Adding paragraph (c)(3)(iv), and
Amending paragraph (c)(8) by adding Example 11, Example 12 and Ex- ample 13.
The additions and revisions read as follows:

§1.904–4 Separate application of section 904 with respect to certain categories of income.

February 1, 1999 24 1999–5 I.R.B.

high-taxed income, the grouping rules of paragraphs (c)(3)(i) and (ii), (c)(4), and (c)(5) of this section apply to taxable years beginning after December 31, 1987. Except as provided in paragraph (c)(2)(i)(B) of this section, the rules of paragraph (c)(3)(iii) apply to taxable years beginning after December 31, 1987, and ending before December 31, 1998, and the rules of paragraph (c)(3)(iv) apply to taxable years ending on or after December 31, 1998. See Notice 87–6 (19871 C.B.417) for the grouping rules applicable to taxable years beginning after December 31, 1986 and before January 1, 1988. The fourth sentence of paragraph (c)(2)(ii)(A) and paragraph (c)(2)(ii)(B) of this section are effective for taxable years beginning after March 12, 1999.

(B) Application to prior periods. A taxpayer may apply the rules of paragraph (c)(3)(iv) to any taxable year beginning after December 31, 1991, and all subsequent years, provided that—

( 1 ) The taxpayer’s tax liability as shown on an original or amended tax return is consistent with the rules of this section for each such year for which the statute of limitations does not preclude the filing of an amended return on June 30, 1999; and ( 2 ) The taxpayer makes appropriate adjustments to eliminate any double benefit arising from the application of this section to years that are not open for assessment.

(ii) Grouping rules —(A) Initial alloca- tion and apportionment of deductions and taxes. For purposes of determining whether passive income is high-taxed, expenses, losses and other deductions shall be allocated and apportioned initially to each of the groups of passive income (described in paragraphs (c)(3), (4), and (5) of this section) under the rules of §§1.861–8 through 1.861–14T and 1.865– 1T through 1.865–2T. Taxpayers that allocate and apportion interest expense on an asset basis may nevertheless apportion passive interest expense among the groups of passive income on a gross income basis. Foreign taxes are allocated to groups under the rules of §1.904–6(a)(iii). If a loss on a disposition of property gives rise to foreign tax (i.e., the transaction

giving rise to the loss is treated under foreign law as having given rise to a gain), the foreign tax shall be allocated to the group of passive income to which gain on the sale would have been assigned under paragraph (c)(3) or (4) of this section. A determination of whether passive income is high-taxed shall be made only after application of paragraph (c)(2)(ii)(B) of this section (if applicable).

(B) Reallocation of loss groups. If, after allocation and apportionment of expenses, losses and other deductions under paragraph (c)(2)(ii)(A) of this section, the sum of the allocable deductions exceeds the gross income in one or more groups, the excess deductions shall proportionately reduce income in the other groups (but not below zero).

(3) * * * (iii) For taxable years ending before December 31, 1998 (except as provided in paragraph (c)(2)(i)(B) of this section), all passive income received during the taxable year that is subject to no withholding tax shall be treated as one item of income.

(iv) For taxable years ending on or after December 31, 1998, all passive income received during the taxable year that is subject to no withholding tax or other foreign tax shall be treated as one item of income, and all passive income received during the taxable year that is subject to no withholding tax but is subject to a foreign tax other than a withholding tax shall be treated as one item of income.

(8) * * *

Example 11. In 2001, P, a U.S. citizen with a tax home in Country X, earns the following items of gross income: $400 of foreign source, passive limitation interest income not subject to foreign withholding tax but subject to Country X income tax of $100, $200 of foreign source, passive limitation royalty income subject to a 5 percent foreign withholding tax (foreign tax paid is $10), $1,300 of foreign source, passive limitation rental income subject to a 25 percent foreign withholding tax (foreign tax paid is $325), $500 of foreign source, general limitation income that gives rise to a $250 foreign tax, and $2,000 of U.S. source capital gain that is not subject to any foreign tax. P has a $900 deduction allocable to its passive rental income. P ’s only other deduction is a $700 capital loss on the sale of stock that is

allocated to foreign source passive limitation income under §1.865–2(a)(3)(i). The $700 capital loss is initially allocated to the group of passive income subject to no withholding tax but subject to foreign tax other than withholding tax. The $300 amount by which the capital loss exceeds the income in the group must be reapportioned to the other groups under paragraph (c)(2)(ii)(B) of this section. The royalty income is thus reduced by $100 to $100 ($200 – ($300 � (200/600))) and the rental income is thus reduced by $200 to $200 ($400 – ($300 (400/600))). The $100 royalty income is not hightaxed and remains passive income because the foreign taxes do not exceed the highest United States rate of tax on that income. Under the high-tax kickout, the $200 of rental income and the $325 of associated foreign tax are assigned to the general limitation category.

Example 12. The facts are the same as in Exam- ple 11 except the amount of the capital loss that is allocated under §1.865–2(a)(3)(i) and paragraph (c)(2) of this section to the group of foreign source passive income subject to no withholding tax but subject to foreign tax other than withholding tax is $1,200. Under paragraph (c)(2)(ii)(B) of this section, the excess deductions of $800 must be reapportioned to the $200 of net royalty income subject to a 5 percent withholding tax and the $400 of net rental income subject to a 15 percent or greater withholding tax. The income in each of these groups is reduced to zero, and the foreign taxes imposed on the rental and royalty income are considered related to general limitation income. The remaining loss of $200 constitutes a separate limitation loss with respect to passive income.

Example 13. In 2001, P, a domestic corporation, earns a $100 dividend that is foreign source passive limitation income subject to a 30-percent withholding tax. A foreign tax credit for the withholding tax on the dividend is disallowed under section 901(k). A deduction for the tax is allowed, however, under sections 164 and 901(k)(7). In determining whether P ’s passive income is high-taxed, the $100 dividend and the $30 deduction are allocated to the first group of income described in paragraph (c)(3)(iv) of this section (passive income subject to no withholding tax or other foreign tax).

Robert E. Wenzel, Deputy Commissioner of

Internal Revenue.

Approved December 15, 1998.

Donald C. Lubick, Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on January 8, 1999, 8:45 a.m., and published in the issue of the Federal Register for January 11, 1999, 64 F.R. 1505)

1999–5 I.R.B 25 February 1, 1999