Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

79, 84 (1992); Commissioner v. Idaho Power Co., 418 U.S. 1, 16 (1974). Moreover, as the Supreme Court has specifically recognized, the “decisive distinctions [between capital and ordinary expenditures] are those of degree and not of kind,” and a careful examination of the particular facts of each case is required. Deputy v. du Pont, 308 U.S. 488, 496 (1940); Welch v. Helvering, 290 U.S. 111, 114 (1933).

In determining whether a current deduction or capitalization is the appropriate tax treatment for an expenditure, it is important to consider the extent to which the expenditure will produce future benefits. See IN- DOPCO, 503 U.S. at 87–88. ISO 9000 certification potentially results in a number of benefits for a taxpayer. For example, certification may improve the overall quality of the taxpayer’s business operations, give the taxpayer a marketing advantage by differentiating it from non-certified competitors, enable the taxpayer to retain customers that begin requiring their suppliers to be certified, and enable the taxpayer to expand its existing business to new markets and new customers that require their suppliers to be certified. These benefits generally both relate to the current taxable year and extend beyond the taxable year in which the taxpayer obtains ISO 9000 certification. Section 263(a), however, requires an examination of not only the duration of the benefits, but also the extent of the benefits. See IN- DOPCO, 503 U.S. at 87 (the mere presence of an incidental future benefit may not warrant capitalization). See also Rev. Rul. 96–62, 1996–2 C.B. 9 (training costs generally are deductible under § 162 even though they may have some future benefit); Rev. Rul. 94–12, 1994–1 C.B. 36 (incidental repair costs generally are deductible under § 162 even though they may have some future benefit); Rev. Rul. 92–80, 1992–2 C.B. 57 (advertising costs generally are deductible under § 162 even though they may have some future effect on business activities).

ISO 9000 certification does not result in future benefits that are more than incidental. The benefits derived from ISO 9000 certification are akin to the current benefits derived from advertising, training, and similar expenditures incurred in operating the taxpayer’s business, retaining existing customers, or simply improving the overall quality or attractiveness of the taxpayer’s

Section 162.–Trade or Business Expenses

26 CFR 1.162-1: Business expenses. (Also §§ 263, 263A; §§ 1.263(a)-1, 1.263(a)–2, 1.263A–1)

Business expenses; capital expendi- tures; ISO 9000 costs. Costs incurred by a taxpayer to obtain, maintain, and renew ISO 9000 certification are deductible as ordinary and necessary business expenses under section 162 of the Code, except to the extent they result in the creation or acquisition of an asset having a useful life substantially beyond the taxable year (e.g., a quality manual). Rev. Proc. 99–49 modified and amplified.

Rev. Rul. 2000–4

ISSUE

Are costs incurred by a taxpayer to obtain, maintain, and renew ISO 9000 certification deductible as ordinary and necessary business expenses under § 162 of the Internal Revenue Code, or must they be capitalized under §§ 263 or 263A?

FACTS

ISO 9000 is a series of international standards for quality management systems that was developed by the International Organization for Standardization (ISO). The ISO 9000 series of standards is comprised of several specific requirements that are intended to ensure a quality process in providing services or products to an organization’s customers.

To obtain ISO 9000 certification, an organization may incur internal and external costs to assess its current quality processes, create a quality manual, train its employees, and implement the new quality system. In addition, the organization incurs costs to obtain formal certification from an independent auditor (or “registrar”) that its quality management system conforms to a specific ISO 9000 standard. This certification generally lasts from two to four years. After the initial certification, the organization incurs additional costs for periodic audits to maintain its certification and to renew the certification upon expiration of the initial certification pe

riod. All these expenditures are referred to herein as “ISO 9000 costs.”

Although ISO 9000 certification is voluntary, it increasingly is a contractual requirement for doing business with many organizations, both public and private, worldwide. ISO 9000 certification also is an alternative to product certification in some foreign markets, particularly the European Union.

LAW AND ANALYSIS

Section 162 and § 1.162–1(a) of the Income Tax Regulations generally allow a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Courts generally have construed § 162 as containing five conditions that an expenditure must meet to qualify for deduction. The expenditure must be (1) an expense, (2) ordinary, (3) necessary, (4) paid or incurred during the taxable year, and (5) made to carry on a trade or business. See Commissioner v. Lincoln Sav. and Loan Ass’n, 403 U.S. 345 (1971).

Section 263(a) and § 1.263(a)–1(a) provide that no deduction is allowed for any amount paid out for permanent improvements or betterments made to increase the value of any property or estate. Section 1.263(a)–2(a) provides that capital expenditures include the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year.

Section 263A provides that the direct and indirect costs properly allocable to real or tangible personal property produced by the taxpayer or real or personal property described in § 1221(1) that is acquired by the taxpayer for resale must be capitalized. Section 1.263A–1(e)(4)(iv)(F) cites quality control policy as an example of an indirect cost that generally is not allocated to production or resale activities.

Through provisions such as §§ 162(a), 263(a), and 263A, the Code generally endeavors to match expenses with the revenues of the taxable period to which the expenses are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes. See, e.g., IN- DOPCO, Inc. v. Commissioner, 503 U.S.

2000–4 I.R.B. 331 January 24, 2000

business operations. Although the enhanced marketability of the taxpayer’s services or products resulting from ISO 9000 certification may yield future benefits such as repeat business or increased market share, these future benefits are incidental to the primary benefit of current sales. Expenditures that primarily benefit current operations generally are deductible. See, e.g., Van Iderstine Co. v. Commissioner, 261 F.2d 211 (2 ^nd Cir. 1958) (payments made to suppliers to ensure a continuing supply of raw materials were deductible); Snow v. Com- missioner, 31 T.C. 585 (1958), acq., 1959–2 C.B. 7 (payments made to protect and supplement the taxpayer’s income from its existing law business were deductible). See also T.J. Enterprises, Inc. v. Commissioner, 101 T.C. 581 (1993) (expenses incurred to protect, maintain, or preserve a taxpayer’s business generally are deductible).

Further, even if ISO 9000 certification facilitates the expansion of the taxpayer’s existing business, the mere ability to sell in new markets and to new customers, without more, does not result in significant future benefits. Compare Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775 (2 ^nd

Cir. 1973) (expenditures incurred by the taxpayer to develop a new market for wholesale customers, which gave the taxpayer little more than an expectation or hope of future sales, were deductible under § 162); Sun Microsystems v. Commissioner, T.C. Memo 1993–467 (costs incurred to promote sales of computer workstations were not capital expenditures because the anticipated long-term benefits from the customer relationship were “softer” and more speculative than the immediate benefits from the sales) with FMR Corp. v. Commissioner, 110 T.C. 402 (1998) (costs to develop and launch mutual funds, which resulted in new long-term management contracts, were capital expenditures).

Because ISO 9000 certification yields only incidental future benefits, ISO 9000 costs are distinguishable from costs incurred to obtain licenses, stock trading privileges, state bar certifications, and similar marketentry requirements that have been held to be capital expenditures. Unlike ISO 9000 certification, these requirements are an essential element to the establishment of the taxpayer’s business and result either in a separate and distinct asset or in significant future benefits. See, e.g., Nachman v. Com- missioner, 191 F.2d 934 (5 ^th Cir. 1951)

(payment to obtain liquor license was a capital expenditure); Harman v. Commissioner, 72 T.C. 362 (1979) (initiation fees required to obtain a seat on the New York Stock Exchange were capital expenditures); Sharon v. Commissioner, 66 T.C. 515 (1976), aff’d, 591 F.2d 1273 (9 ^th Cir. 1978) (costs incurred by an attorney for admission to various bars were capital expenditures).

Accordingly, ISO 9000 certification does not itself result in the creation of an asset having a useful life substantially beyond the taxable year. To the extent the ISO 9000 certification process results in the creation of an asset, however, § 263(a) requires capitalizing the costs allocable to creating that asset. For example, the costs of creating a quality manual must be capitalized, even though costs of periodic updates to the manual may be deducted. § 263A; § 1.263A–2(a)(2)(ii) , Domestic Management Bureau v. Commissioner, 38 B.T.A. 640 (1938) (costs of preparing and printing a training manual were capital expenditures); Rev. Rul. 96–62 (costs of routine updates of training materials are deductible). In addition, if the certification process requires the acquisition of an asset, such as machinery and equipment, the costs of that asset must be capitalized under § 263(a).

Further, ISO 9000 costs, other than costs incurred during the certification process that are allocable to creating an asset such as a quality manual, are not costs that are allocable to production or resale activities for purposes of the uniform capitalization rules of § 263A, and thus are not subject to the rules set forth in that section or the regulations thereunder. See § 1.263A–1(e)(4)(iv)(F) (quality control expenditures generally excepted from uniform capitalization rules).

HOLDING

Costs incurred by a taxpayer to obtain, maintain, and renew ISO 9000 certification are deductible as ordinary and necessary business expenses under § 162, except to the extent they result in the creation or acquisition of an asset having a useful life substantially beyond the taxable year ( e.g., a quality manual).

APPLICATION

Any change in a taxpayer’s method of accounting to conform with this revenue ruling is a change in method of accounting to which the provisions of §§ 446 and 481 and the regulations thereunder apply.

A taxpayer wanting to change its method of accounting to conform with the holding in this revenue ruling must follow the automatic change in accounting method provisions of Rev. Proc. 99–49, 1999–52 I.R.B. 725, except that the scope limitations in section 4.02 of Rev. Proc. 99-49 do not apply. However, if the taxpayer is under examination, before an appeals office, or before a federal court with respect to any income tax issue, the taxpayer must provide a copy of the Form 3115, Application for Change in Accounting Method, to the examining agent(s), appeals officer, or counsel for the government, as appropriate, at the same time that it files the copy of the Form 3115 with the national office. The Form 3115 must contain the name(s) and telephone number(s) of the examining agent(s), appeals officer, or counsel for the government, as appropriate.

EFFECT ON OTHER DOCUMENTS

Rev. Proc. 99–49 is modified and amplified to include the prospective change in accounting method in the APPENDIX.

DRAFTING INFORMATION

The principal author of this revenue ruling is Kimberly L. Koch of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Ms. Koch at (202) 622-4950 (not a toll-free call).

Section 263.—Capital Expenditures

26 CFR 1.263(a)–1: Capital expenditures; in general.

Are costs incurred by a taxpayer to obtain, maintain, and renew ISO 9000 certification deductible as ordinary and necessary business expenses under §162, except to the extent they result in the creation or acquisition of an asset having a useful life substantially beyond the taxable year (e.g., a quality manual)? See Rev. Rul. 2000–4, page 331.

Section 338.—Certain Stock Purchases Treated As Asset Acquisitions

26 CFR 1.338–1T: General principles; status of old target and new target (temporary).

January 24, 2000 332 2000–4 I.R.B.

I.R.B. 346)) a notice of proposed rulemaking. The notice contained proposed regulations under sections 338 and 1060 of the Internal Revenue Code of 1986. The temporary and final regulations promulgated in this Treasury decision are substantively the same as the proposed regulations published on August 10, 1999. The Service and Treasury believe that the comments received on the proposed regulations warrant further consideration. For instance, the Service and the Treasury received several comments requesting reconsideration of (1) the provision in §1.338–3(b)(2)(ii) of the proposed regulations stating that a purchase of target stock occurs only so long as more than a nominal amount is paid for such share, and (2) the example in §1.338–1(a)(2) of the proposed regulations stating that if target is an insurance company for which a section 338 election is made, then the deemed asset sale will be characterized and taxed as an assumptionreinsurance transaction. The temporary regulations reserve the purchase issue addressed in §1.338–3(b)(2)(ii) of the proposed regulations pending further consideration of the comments. The temporary regulations retain the assumption-reinsurance example because the example properly illustrates the principles of the proposed and temporary regulations. The Service and Treasury will give further consideration to the interaction of section 338 and the assumption-reinsurance rules and the need for additional guidance on how the assumption-reinsurance rules should work in the context of a deemed asset sale.

Notwithstanding such comments, the proposed regulations generally were favorably received, and the Service and Treasury are convinced that, in general, the proposed regulations provide clearer guidance and better rules than the current final and temporary regulations under sections 338 and 1060. Accordingly, pending further review of the comments received on the proposed regulations, the Service and Treasury are replacing existing temporary and final regulations with the proposed rules published on August 10, 1999.

As soon as feasible, final regulations will be promulgated, replacing these new temporary regulations. All comments received in response to the requests for comments contained in the notice of August 10, 1999, will be considered in the course of preparing the final regulations.

T.D. 8858

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

Purchase Price Allocations in Deemed and Actual Asset Acquisitions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains temporary regulations relating to the allocation of purchase price in deemed and actual asset acquisitions. The temporary regulations determine the amount realized and the amount of basis allocated to each asset transferred in a deemed or actual asset acquisition and affect transactions reported on either Form 8023 or Form 8594. The intended effect of the temporary regulations is to remove and replace many of the current temporary and final regulations sections under sections 338 and 1060 and renumber others.

DATES: Effective Date : These regulations are effective January 6, 2000.

Applicability Dates : For dates of applicability of these regulations, see §1.338(i)–1T and §1.1060–1T(a)(2).

FOR FURTHER INFORMATION CONTACT: Richard Starke of the Office of Assistant Chief Counsel (Corporate), (202) 622-7790 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these temporary regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under the control number 1545-1658.

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

The collections of information in these

temporary regulations are in §§1.338–2T(d), 1.338–2T(e)(4), 1.338–5T(d)(3), 1.338–10T(a)(4), 1.338(h)(10)–1T(d)(2), and 1.1060–1T(e)(ii)(A) and (B). The collections of information are necessary to make an election to treat a sale of stock as a sale of assets, to calculate and collect the appropriate amount of tax in a deemed or actual asset acquisition, and to determine the bases of assets acquired in a deemed or actual asset acquisition.

These collections of information are required to obtain a benefit. The likely respondents and/or recordkeepers are small businesses or organizations, businesses, or other for-profit institutions, and farms.

The regulation provides that a section 338 election is made by filing Form 8023. The burden for this requirement is reflected in the burden of Form 8023. The regulation also provides that both a seller and a purchaser must each file an asset acquisition statement on Form 8594. The burden for this requirement is reflected in the burden of Form 8594.

The burden for the collection of information in §1.338–2T(e)(4) is as follows: Estimated total annual reporting/recordkeeping burden: 25 hours Estimated average annual burden per respondent/recordkeeper: 0.56 hours Estimated number of respondents/recordkeepers: 45 Estimated annual frequency of responses: On occasion

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 a 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 August 10, 1999, the IRS and Treasury published in the Federal Register (REG–107069–97, 64 FR 43461 (1999–36

2000–4 I.R.B. 333 January 24, 2000

ther information would be arbitrary. Instead, these regulations authorize the Commissioner to exclude certain transactions from the reporting requirements.

Drafting Information

The principal author of these regulations is Richard Starke, Office of the Assistant Chief Counsel (Corporate). However, other personnel from the IRS and Treasury Department participated extensively 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 is amended by removing the entries for 1.338(b)–1, 1.338(b)–3T, and 1.1060–1T and by adding entries in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.338–6T also issued under 26 U.S.C. 337(d), 338, and 1502. Section 1.338–7T also issued under 26 U.S.C. 337(d), 338, and 1502. Section 1.338–8 also issued under 26 U.S.C. 337(d), 338, and 1502. Section 1.338–9 also issued under 26 U.S.C. 337(d), 338, and 1502. Section 1.338–10T also issued under 26

Special Analyses

It has been determined that these temporary regulations are not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has been determined that a final regulatory flexibility analysis is required for the collection of information in this Treasury decision under 5 U.S.C. 604. This analysis is set forth below under the heading “Final Regulatory Flexibility Act Analysis.” Pursuant to section 7805(f) of the Internal Revenue Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Final Regulatory Flexibility Act Analysis

This analysis is required under the Regulatory Flexibility Act (5 U.S.C. chapter 6). This regulatory action is intended to simplify and clarify the current rules relating to both deemed and actual asset acquisitions. The current rules were developed over a long period of time and have been repeatedly amended. The IRS and Treasury believe these temporary regulations will significantly improve the clarity of the rules relating to both deemed and actual asset acquisitions.

The major objective of these temporary regulations is to modify the rules for allocating purchase price in both deemed and

in a qualified stock purchase or if a trade or business which is also a small business is transferred in a taxable transaction. Form 8023 (on which an election to treat a stock sale as an asset sale is filed) has been submitted to and approved by the Office of Management and Budget. With respect to Form 8023, the IRS estimated that 201 forms would be filed each year and that each taxpayer would require 12.98 hours to comply. Form 8594 (on which a sale or acquisition of assets constituting a trade or business is reported) has also been submitted to and approved by the Office of Management and Budget. With respect to Form 8594, the IRS estimated that 20,000 forms would be filed each year and that each taxpayer would require 12.25 hours to comply. These estimates have been made available for public comment and no public comments have been received. The regulations do not impose new requirements on small businesses and, in fact, should lessen any difficulties associated with the existing reporting requirements by clarifying the rules associated with deemed and actual asset acquisitions.

The collections of information require taxpayers to file an election in order to treat a stock sale as an asset sale. In addition, taxpayers must file a statement regarding the amount of consideration allocated to each class of assets under the residual method. The professional skills that would be necessary to make the election or allocate the consideration would

January 24, 2000 334 2000–4 I.R.B.

(vi) Good faith effort to comply.

§1.338–3T Qualification for the section 338 election (temporary).

(a) Scope. (b) Rules relating to qualified stock pur chases. (1) Purchasing corporation requirement. (2) Purchase. (i) Definition. (ii) Purchase of target. [Reserved] (iii) Purchase of target affiliate. (3) Acquisitions of stock from related

corporations. (i) In general. (ii) Time for testing relationship. (iii) Cases where section 338(h)(3)(C) ap plies—acquisitions treated as purchases. (iv) Examples. (4) Acquisition date for tiered targets. (i) Stock sold in deemed asset sale. (ii) Examples. (5) Effect of redemptions. (i) General rule. (ii) Redemptions from persons unrelated

to the purchasing corporation. (iii) Redemptions from the purchasing

corporation or related persons during 12-month acquisition period. (A) General rule. (B) Exception for certain redemptions

from related corporations. (iv) Examples. (c) Effect of post-acquisition events on el igibility for section 338 election.

§1.338–0 through 1.338–3 [Removed]

Par. 3. Sections 1.338–0 through 1.338–3 are removed. Par. 4. Sections 1.338–0T through 1.338–3T are added to read as follows: §1.338–0T Outline of topics (temporary).

This section lists the captions contained in the regulations under section 338 as follows: §1.338–1T General principles; status of old target and new target (temporary).

(a) In general. (1) Deemed transaction. (2) Application of other rules of law. (3) Overview. (b) Treatment of target under other provi sions of the Internal Revenue Code. (1) General rule for subtitle A. (2) Exceptions for subtitle A. (3) General rule for other provisions of the Internal Revenue Code. (c) Anti-abuse rule. (1) In general. (2) Examples.

(a) In general. (1) Deemed transaction. (2) Application of other rules of law. (3) Overview. (b) Treatment of target under other provi

§1.338–2T Nomenclature and defini- tions; mechanics of the section 338 elec- tion (temporary).

(a) Scope. (b) Nomenclature. (c) Definitions. (1) Acquisition date. (2) Acquisition date assets. (3) Affiliated group. (4) Common parent. (5) Consistency period.

(6) Deemed asset sale. (7) Deemed sale gain. (8) Deemed sale return. (9) Domestic corporation. (10) Old target’s final return. (11) Purchasing corporation. (12) Qualified stock purchase. (13) Related persons. (14) Section 338 election. (15) Section 338(h)(10) election. (16) Selling group. (17) Target; old target; new target. (18) Target affiliate. (19) 12-month acquisition period. (d) Time and manner of making election. (e) Special rules for foreign corporations

or DISCs. (1) Elections by certain foreign purchas ing corporations. (i) General rule. (ii) Qualifying foreign purchasing corpo ration. (iii) Qualifying foreign target. (iv) Triggering event. (v) Subject to United States tax. (2) Acquisition period. (3) Statement of section 338 may be filed

by United States shareholders in certain cases. (4) Notice requirement for U.S. persons

holding stock in foreign market. (i) General rule. (ii) Limitation. (iii) Form of notice. (iv) Timing of notice. (v) Consequence of failure to comply.

2000–4 I.R.B. 335 January 24, 2000

de minimis assets. (4) Mitigation rule. (i) General rule. (ii) Time for transfer.

(1) Post-acquisition elimination of target. (2) Post-acquisition elimination of the

purchasing corporation. (3) Consequences of post-acquisition

elimination of target. (i) Scope. (ii) Continuity of interest. (iii) Control requirement. (iv) Example.

§1.338-4T Aggregate deemed sale price; various aspects of taxation of the deemed asset sale (temporary).

(a) Scope. (b) Determination of ADSP. (1) General rule. (2) Time and amount of ADSP. (i) Original determination. (ii) Redetermination of ADSP. (iii) Example. (c) Grossed-up amount realized on the

sale to the purchasing corporation of the purchasing corporation’s recently purchased target stock. (1) Determination of amount. (2) Example. (d) Liabilities of old target. (1) In general. (2) Time and amount of liabilities. (3) Interaction with deemed sale gain. (e) Calculation of deemed sale gain. (f) Other rules apply in determining

ADSP. (g) Examples. (h) Deemed sale of target affiliate stock. (1) Scope. (2) In general. (3) Deemed sale of foreign target affiliate

by a domestic target. (4) Deemed sale producing effectively

connected income. (5) Deemed sale of insurance company

target affiliate electing under section 953(d). (6) Deemed sale of DISC target affiliate. (7) Anti-stuffing rule. (8) Examples.

§1.338–5T Adjusted grossed-up basis (temporary).

( a) Scope. (b) Determination of AGUB. (1) General rule. (2) Time and amount of AGUB. (i) Original determination. (ii) Redetermination of AGUB. (iii) Examples. (c) Grossed-up basis of recently pur

chased stock. (d) Basis of nonrecently purchased stock;

gain recognition election. (1) No gain recognition election. (2) Procedure for making gain recogni tion election. (3) Effect of gain recognition election. (i) In general. (ii) Basis amount. (iii) Losses not recognized. (iv) Stock subject to election. (e) Liabilities of new target. (1) In general. (2) Time and amount of liabilities. (3) Interaction with deemed sale gain. (f) Adjustments by the Internal Revenue

Service. (g) Examples.

§1.338–6T Allocation of ADSP and AGUB among target assets (temporary).

(a) Scope. (1) In general. (2) Fair market value. (i) In general. (ii) Transaction costs. (iii) Internal Revenue Service authority. (b) General rule for allocating ADSP and

AGUB. (1) Reduction in the amount of considera tion for Class I assets. (2) Other assets. (i) In general. (ii) Class II assets. (iii) Class III assets. (iv) Class IV assets. (v) Class V assets. (vi) Class VI assets. (vii) Class VII assets. (3) Other items designated by the Internal

Revenue Service. (c) Certain limitations and other rules for

allocation to an asset. (1) Allocation not to exceed fair market

value. (2) Allocation subject to other rules. (3) Special rule for allocating AGUB

when purchasing corporation has nonrecently purchased stock. (i) Scope. (ii) Determination of hypothetical pur chase price. (iii) Allocation of AGUB. (4) Liabilities taken into account in deter mining amount realized on subsequent disposition. (d) Examples.

§1.338–7T Allocation of redetermined

ADSP and AGUB among target assets (temporary).

(a) Scope. (b) Allocation of redetermined ADSP and

AGUB. (c) Special rules for ADSP. (1) Increases or decreases in deemed sale

gain taxable notwithstanding old target ceases to exist. (2) Procedure for transactions in which

section 338(h)(10) is not elected. (i) Deemed sale gain included in new tar get’s return. (ii) Carryovers and carrybacks. (A) Loss carryovers to new target taxable

years. (B) Loss carrybacks to taxable years of

old target. (C) Credit carryovers and carrybacks. (3) Procedure for transactions in which

section 338(h)(10) is elected. (d) Special rules for AGUB. (1) Effect of disposition or depreciation of

acquisition date assets. (2) Section 38 property. (e) Examples.

§1.338–8 Asset and stock consistency.

(a) Introduction. (1) Overview. (2) General application. (3) Extension of the general rules. (4) Application where certain dividends

are paid. (5) Application to foreign target affiliates. (6) Stock consistency. (b) Consistency for direct acquisitions. (1) General rule. (2) Section 338(h)(10) elections. (c) Gain from disposition reflected in

basis of target stock. (1) General rule. (2) Gain not reflected if section 338 elec tion made for target. (3) Gain reflected by reason of distribu tions. (4) Controlled foreign corporations. (5) Gain recognized outside the consoli dated group. (d) Basis of acquired assets. (1) Carryover basis rule. (2) Exceptions to carryover basis rule for

certain assets. (3) Exception to carryover basis rule for

January 24, 2000 336 2000–4 I.R.B.

(e) Examples. (1) In general. (2) Direct acquisitions. (f) Extension of consistency to indirect

acquisitions. (1) Introduction. (2) General rule. (3) Basis of acquired assets. (4) Examples. (g) Extension of consistency if dividends

qualifying for 100 percent dividends received deduction are paid. (1) General rule for direct acquisitions

from target. (2) Other direct acquisitions having same

effect. (3) Indirect acquisitions. (4) Examples. (h) Consistency for target affiliates that

are controlled foreign corporations. (1) In general. (2) Income or gain resulting from asset

dispositions. (i) General rule. (ii) Basis of controlled foreign corpora tion stock. (iii) Operating rule. (iv) Increase in asset or stock basis. (3) Stock issued by target affiliate that is a

controlled foreign corporation. (4) Certain distributions. (i) General rule. (ii) Basis of controlled foreign corpora tion stock. (iii) Increase in asset or stock basis. (5) Examples. (i) [Reserved] (j) Anti-avoidance rules. (1) Extension of consistency rules. (2) Qualified stock purchase and 12 month acquisition period. (3) Acquisitions by conduits. (i) Asset ownership. (A) General rule. (B) Application of carryover basis rule. (ii) Stock acquisitions. (A) Purchase by conduit. (B) Purchase of conduit by corporation. (C) Purchase of conduit by conduit. (4) Conduit. (5) Existence of arrangement. (6) Predecessor and successor. (i) Persons. (ii) Assets. (7) Examples.

§1.338–9 International aspects of section 338.

(a) Scope. (b) Application of section 338 to foreign

targets. (1) In general. (2) Ownership of FT stock on the acquisi tion date. (3) Carryover FT stock. (i) Definition. (ii) Carryover of earnings and profits. (iii) Cap on carryover of earnings and

profits. (iv) Post-acquisition date distribution of

old FT earnings and profits. (v) Old FT earnings and profits unaf fected by post-acquisition date deficits. (vi) Character of FT stock as carryover

FT stock eliminated upon disposition. (4) Passive foreign investment company

stock. (c) Dividend treatment under section

1248(e). (d) Allocation of foreign taxes. (e) Operation of section 338(h)(16). [Re served] (f) Examples.

§1.338–10T Filing of returns (temporary).

(a) Returns including tax liability from

deemed asset sale. (1) In general. (2) Old target’s final taxable year other wise included in consolidated return of selling group. (i) General rule. (ii) Separate taxable year. (iii) Carryover and carryback of tax attrib utes. (iv) Old target is a component member of

purchasing corporation’s controlled group. (3) Old target is an S corporation. (4) Combined deemed sale return. (i) General rule. (ii) Gain and loss offsets. (iii) Procedure for filing a combined re turn. (iv) Consequences of filing a combined

return. (5) Deemed sale excluded from purchas ing corporation’s consolidated return. (6) Due date for old target’s final return. (i) General rule. (ii) Application of §1.1502–76(c). (A) In general. (B) Deemed extension. (C) Erroneous filing of deemed sale re

turn. (D) Erroneous filing of return for regular

tax year. (E) Last date for payment of tax. (7) Examples. (b) Waiver. (1) Certain additions to tax. (2) Notification. (3) Elections or other actions required to

be specified on a timely filed return. (i) In general. (ii) New target in purchasing corpora tion’s consolidated return. (4) Examples.

§1.338(h)(10)–1T Deemed asset sale and liquidation (temporary).

(a) Scope. (b) Definitions. (1) Consolidated target. (2) Selling consolidated group. (3) Selling affiliate; affiliated target. (4) S corporation target (5) S corporation shareholders. (6) Liquidation. (c) Section 338(h)(10) election. (1) In general. (2) Simultaneous joint election require ment. (3) Irrevocability. (4) Effect of invalid election. (d) Certain consequences of section

338(h)(10) election. (1) P. (2) New T. (3) Old T—deemed sale. (i) In general. (ii) Tiered targets. (4) Old T and selling consolidated group,

selling affiliate, or S corporation shareholders—deemed liquidation; tax characterization. (i) In general. (ii) Tiered targets. (5) Selling consolidated group, selling af filiate, or S corporation shareholders. (i) In general. (ii) Basis and holding period of T stock

not acquired. (iii) T stock sale. (6) Nonselling minority shareholders

other than nonselling S corporation shareholders. (i) In general. (ii) T stock sale. (iii) T stock not acquired. (7) Consolidated return of selling consoli dated group.

2000–4 I.R.B. 337 January 24, 2000

(8) Availability of the section 453 install ment method. (i) In deemed asset sale. (ii) In deemed liquidation. (9) Treatment consistent with an actual

asset sale. (e) Examples. (f) Inapplicability of provisions. (g) Required information.

§1.338(i)–1T Effective dates (temporary). §1.338–1T General principles; status of old target and new target (temporary).

(a) In genera l—(1) Deemed transac- tion. Elections are available under section 338 when a purchasing corporation acquires the stock of another corporation (the target) in a qualified stock purchase. One type of election, under section 338(g), is available to the purchasing corporation. Another type of election, under section 338(h)(10), is, in more limited circumstances, available jointly to the purchasing corporation and the sellers of the stock. (Rules concerning eligibility for these elections are contained in §§ 1.338–2T, 1.338–3T, and 1.338(h)(10)–1T.) Although target is a single corporation under corporate law, if a section 338 election is made, then two separate corporations, old target and new target, generally are considered to exist for purposes of subtitle A of the Internal Revenue Code. Old target is treated as transferring all of its assets to an unrelated person in exchange for consideration that includes the assumption of, or taking subject to, liabilities, and new target is treated as acquiring all of its assets from an unrelated person in exchange for consideration that includes the assumption of or taking subject to liabilities. (Such transaction is, without regard to its characterization for Federal income tax purposes, referred to as the deemed asset sale and the income tax consequences thereof as the deemed sale gain.) If a section 338(h)(10) election is made, old target is also deemed to liquidate following the deemed asset sale.

(2) Application of other rules of law . Other rules of law apply to determine the tax consequences to the parties as if they had actually engaged in the transactions deemed to occur under section 338 and §§1.338–0T through 1.338–7T, 1.338–8, 1.338–9, 1.338–10T, 1.338(h)(10)–1T, and 1.338(i)–1T except to the extent otherwise provided in §§1.338–0T through

1.338–7T, 1.338–8, 1.338–9, 1.338–10T, 1.338(h)(10)–1T, and 1.338(i)–1T. See also §1.338–6T(c)(2). Other rules of law may characterize the transaction as something other than or in addition to a sale and purchase of assets; however, it must be a taxable transaction. For example, if target is an insurance company for which a section 338 election is made, the deemed asset sale would be characterized and taxed as an assumption–reinsurance transaction under applicable Federal income tax law. See §1.817–4(d).

(3) Overview . Definitions and special nomenclature and rules for making the section 338 election are provided in §1.338–2T. Qualification for the section 338 election is addressed in §1.338–3T. The amount for which old target is treated as selling all of its assets (the aggregate deemed sale price, or ADSP) is addressed in §1.338–4T. The amount for which new target is deemed to have purchased all its assets (the adjusted grossed-up basis, or AGUB) is addressed in §1.338–5T. Section 1.338–6T addresses allocation both of ADSP among the assets old target is deemed to have sold and of AGUB among the assets new target is deemed to have purchased. Section 1.338–7T addresses allocation of ADSP or AGUB when those amounts change after the close of new target’s first taxable year. Asset and stock consistency are addressed in §1.338–8. International aspects of section 338 are covered in §1.338–9. Rules for the filing of returns are provided in §1.338–10T. Eligibility for and treatment of section 338(h)(10) elections is addressed in §1.338(h)(10)–1T.

(b) Treatment of target under other pro- visions of the Internal Revenue Code —(1) General rule for subtitle A . Except as provided in this section, new target is treated as a new corporation that is unrelated to old target for purposes of subtitle A of the Internal Revenue Code. Thus—

(i) New target is not considered related to old target for purposes of section 168 and may make new elections under section 168 without taking into account the elections made by old target; and

(ii) New target may adopt, without obtaining prior approval from the Commissioner, any taxable year that meets the requirements of section 441 and any method of accounting that meets the requirements of section 446. Notwithstand

ing §1.441–1T(b)(2), a new target may adopt a taxable year on or before the last day for making the election under section 338 by filing its first return for the desired taxable year on or before that date.

(2) Exceptions for subtitle A . New target and old target are treated as the same corporation for purposes of—

(i) The rules applicable to employee benefit plans (including those plans described in sections 79, 104, 105, 106, 125, 127, 129, 132, 137, and 220), qualified pension, profit-sharing, stock bonus and annuity plans (sections 401(a) and 403(a)), simplified employee pensions (section 408(k)), tax qualified stock option plans (sections 422 and 423), welfare benefit funds (sections 419, 419A, 512(a)(3), and 4976), voluntary employee benefit associations (section 501(c)(9) and the regulations thereunder);

(ii) Sections 1311 through 1314 (relating to the mitigation of the effect of limitations) if a section 338(h)(10) election is not made for target;

(iii) Section 108(e)(5) (relating to the reduction of purchase money debt);

(iv) Section 45A (relating to the Indian Employment Credit), section 51 (relating to the Work Opportunity Credit), section 51A (relating to the Welfare to Work Credit), and section 1396 (relating to the Empowerment Zone Act);

(v) Sections 401(h) and 420 (relating to medical benefits for retirees);

(vi) Section 414 (relating to definitions and special rules);

and (vii) Any other provision designated in the Internal Revenue Bulletin by the Internal Revenue Service. See §601.601(d)(2)(ii) of this chapter (relating to the Internal Revenue Bulletin). See §1.1001–3(e)(4)(F) providing that an election under section 338 does not result in the substitution of a new obligor on target’s debt.

(3) General rule for other provisions of the Internal Revenue Code . Except as provided in the regulations under section 338 or in the Internal Revenue Bulletin by the Internal Revenue Service (see §601.601(d)(2)(ii) of this chapter), new target is treated as a continuation of old target for purposes other than subtitle A of the Internal Revenue Code. For example—

(i) New target is liable for old target’s

January 24, 2000 338 2000–4 I.R.B.

Federal income tax liabilities, including the tax liability for the deemed sale gain and those tax liabilities of the other members of any consolidated group that included old target that are attributable to taxable years in which those corporations and old target joined in the same consolidated return (see §1.1502–6(a));

(ii) Wages earned by the employees of old target are considered wages earned by such employees from new target for purposes of sections 3101 and 3111 (Federal Insurance Contributions Act) and section 3301 (Federal Unemployment Tax Act); and

(iii) Old target and new target must use the same employer identification number.

(c) Anti-abuse rule —(1) In genera l. For purposes of applying the residual method of §§1.338–0T through 1.338–7T, 1.338–8, 1.338–9, 1.338–10T, 1.338(h)(10)–1T, and 1.338(i)–1T, the Commissioner is authorized to treat any property (including cash) transferred by old target in connection with the transactions resulting in the application of the residual method as, nonetheless, property of target at the close of the acquisition date if the property so transferred, within 24 months after the deemed asset sale, is owned by new target, or is owned, directly or indirectly, by a member of the affiliated group of which new target is a member and continues after the election to be held or used to more than an insignificant extent in connection with one or more of the activities of new target. The Commissioner is authorized to treat any property (including cash) transferred to old target in connection with the transactions resulting in the application of the residual method as, nonetheless, not being property of target at the close of the acquisition date if the property so transferred by the transferor is, within 24 months after the deemed asset sale, not owned by new target but owned, directly or indirectly, by a member of the affiliated group of which new target is a member or owned by new target but held or used to more than an insignificant extent in connection with an activity conducted, directly or indirectly, by another member of the affiliated group of which new target is a member in combination with other property acquired, directly or indirectly, from the transferor of the property (or a member of the same affiliated group) to

old target. For purposes of this paragraph (c)(1), an interest in an entity is considered held or used in connection with an activity if property of the entity is so held or used. The authority under this paragraph (c)(1) includes the making of any necessary correlative adjustments.

(2) Examples. The following examples illustrate this paragraph (c):

Example 1 . Prior to a qualified stock purchase under section 338, target transfers one of its assets to a related party. The purchasing corporation then purchases the target stock and also purchases the transferred asset from the related party. After its purchase of target, the purchasing corporation and target are members of the same affiliated group. A section 338 election is made. Under an arrangement with the purchaser, target continues to use the separately transferred asset to more than an insignificant extent in connection with its own activities. Applying the anti-abuse rule of this paragraph (c), the Commissioner may consider target to own the transferred asset for purposes of applying section 338 and its allocation rules.

Example 2 . Target (T) owns all the stock of T1. T1 leases intellectual property to T, which T uses in connection with its own activities. P, a purchasing corporation, wishes to buy the T-T1 chain of corporations. P, in connection with its planned purchase of the T stock, contracts to consummate a purchase of all the stock of T1 on March 1 and of all the stock of T on March 2. Section 338 elections are thereafter made for both T and T1. Immediately after the purchases, P, T and T1 are members of the same affiliated group. T continues to lease the intellectual property from T1 and to use the property to more than an insignificant extent in connection with its own activities. Thus, an asset of T, the T1 stock, was removed from T ‘s own assets prior to the qualified stock purchase of the T stock, T1’s own assets are used after the deemed asset sale in connection with T’s own activities, and the T1 stock is after the deemed asset sale owned by P, a member of the same affiliated group of which T is a member. Applying the anti-abuse rule of this paragraph (c), the Commissioner may, for purposes of application of section 338 both to T and to T1, consider P to have bought only the stock of T, with T at the time of the qualified stock purchases of both T and T1 (the qualified stock purchase of T1 being triggered by the deemed sale under section 338 of T’s assets) owning T1. The Commissioner would accordingly apply section 338 first at the T level and then at the T1 level. §1.338–2T Nomenclature and defini- tions; mechanics of the section 338 elec- tion (temporary).

(a) Scope . This section prescribes rules relating to elections under section 338.

(b) Nomenclature . For purposes of the regulations under section 338 (except as otherwise provided):

(1) T is a domestic target corporation that has only one class of stock outstanding. Old T refers to T for periods ending

on or before the close of T’s acquisition date; new T refers to T for subsequent periods.

(2) P is the purchasing corporation. (3) The P group is an affiliated group of which P is a member.

(4) P1, P2, etc., are domestic corporations that are members of the P group.

(5) T1, T2, etc., are domestic corporations that are target affiliates of T. These corporations (T1, T2, etc.) have only one class of stock outstanding and may also be targets.

(6) S is a domestic corporation (unrelated to P and B) that owns T prior to the purchase of T by P. (S is referred to in cases in which it is appropriate to consider the effects of having all of the outstanding stock of T owned by a domestic corporation.)

(7) A, a U.S. citizen or resident, is an individual (unrelated to P and B) who owns T prior to the purchase of T by P. (A is referred to in cases in which it is appropriate to consider the effects of having all of the outstanding stock of T owned by an individual who is a U.S. citizen or resident. Ownership of T by A and ownership of T by S are mutually exclusive circumstances.)

(8) B, a U.S. citizen or resident, is an individual (unrelated to T, S, and A) who owns the stock of P.

(9) F, used as a prefix with the other terms in this paragraph (b), connotes foreign, rather than domestic, status. For example, FT is a foreign corporation (as defined in section 7701(a)(5)) and FA is an individual other than a U.S. citizen or resident.

(10) CFC, used as a prefix with the other terms in this paragraph (b) referring to a corporation, connotes a controlled foreign corporation (as defined in section 957, taking into account section 953(c)). A corporation identified with the prefix F may be a controlled foreign corporation. The prefix CFC is used when the corporation’s status as a controlled foreign corporation is significant.

(c) Definitions . For purposes of the regulations under section 338 (except as otherwise provided):

(1) Acquisition date. The term acquisi- tion date has the same meaning as in section 338(h)(2).

(2) Acquisition date assets . Acquisition date assets are the assets of the target held

2000–4 I.R.B. 339 January 24, 2000

at the beginning of the day after the acquisition date (other than assets that were not assets of old target).

(3) Affiliated group. The term affili- ated group has the same meaning as in section 338(h)(5). Corporations are affiliated on any day they are members of the same affiliated group.

(4) Common parent . The term common parent has the same meaning as in section 1504. (5) Consistency period. The consis- tency period is the period described in section 338(h)(4)(A) unless extended pursuant to §1.338–8(j)(1).

(6) Deemed asset sale . The deemed asset sale is the transaction described in §1.338–1T(a)(1) that is deemed to occur for purposes of subtitle A of the Internal Revenue Code if a section 338 election is made.

(7) Deemed sale gain. Deemed sale gain refers to, in the aggregate, the Federal income tax consequences (generally, the income, gain, deduction, and loss) of the deemed asset sale. Deemed sale gain also refers to the Federal income tax consequences of the transfer of a particular asset in the deemed asset sale.

(8) Deemed sale return . The deemed sale return is the return on which target’s deemed sale gain is reported that does not include any other items of target. Target files a deemed sale return when a section 338 election (but not a section 338(h)(10) election) is filed for target and target is a member of a selling group (defined in paragraph (c)(16) of this section) that files a consolidated return for the period that includes the acquisition date or is an S corporation. See §1.338–10T.

(9) Domestic corporation. A domestic corporation is a corporation—

(i) That is domestic within the meaning of section 7701(a)(4) or that is treated as domestic for purposes of subtitle A of the Internal Revenue Code (e.g., to which an election under section 953(d) or 1504(d) applies); and

(ii) That is not a DISC, a corporation described in section 1248(e), or a corporation to which an election under section 936 applies. (10) Old target’s final return. Old tar- get’s final return is the income tax return of old target for the taxable year ending at the close of the acquisition date that includes the deemed sale gain. If the disaf

filiation rule of §1.338–10T(a)(2)(i) applies or if target is an S corporation, target’s deemed sale return is considered old target’s final return.

(11) Purchasing corporation. The term purchasing corporation has the same meaning as in section 338(d)(1). The purchasing corporation may also be referred to as purchaser. Unless otherwise provided, any reference to the purchasing corporation is a reference to all members of the affiliated group of which the purchasing corporation is a member. See sections 338(h)(5) and (8). Also, unless otherwise provided, any reference to the purchasing corporation is, with respect to a deemed purchase of stock under section 338(a)(2), a reference to new target with respect to its own deemed purchase of stock in another target.

(12) Qualified stock purchase . The term qualified stock purchase has the same meaning as in section 338(d)(3).

(13) Related persons . Two persons are related if stock in a corporation owned by one of the persons would be attributed under section 318(a) (other than section 318(a)(4)) to the other. (14) Section 338 election . A section 338 election is an election to apply section 338(a) to target. A section 338 election is made by filing a statement of section 338 election pursuant to paragraph (d) of this section. The form on which this statement is filed is referred to in the regulations under section 338 as the Form 8023 Elections Under Section 338 for Corporations Making Qualified Stock Purchases.

(15) Section 338(h)(10) election. A section 338(h)(10) election is an election to apply section 338(h)(10) to target. A section 338(h)(10) election is made by making a joint election for target under §1.338(h)(10)–1T.

(16) Selling group . The selling group is the affiliated group (as defined in section 1504) eligible to file a consolidated return that includes target for the taxable period in which the acquisition date occurs. However, a selling group is not an affiliated group of which target is the common parent on the acquisition date.

(17) Target; old target; new target. Target is the target corporation as defined in section 338(d)(2). Old target refers to target for periods ending on or before the close of target’s acquisition date. New

target refers to target for subsequent periods.

(18) Target affiliate . The term target affiliate has the same meaning as in section 338(h)(6) (applied without section 338(h)(6)(B)(i)). Thus, a corporation described in section 338(h)(6)(B)(i) is considered a target affiliate for all purposes of section 338. If a target affiliate is acquired in a qualified stock purchase, it is also a target.

(19) 12–Month acquisition period . The 12-month acquisition period is the period described in section 338(h)(1), unless extended pursuant to §1.338–8(j)(2).

(d) Time and manner of making elec- tion . The purchasing corporation makes a section 338 election for target by filing a statement of section 338 election on Form 8023 in accordance with the instructions to the form. The section 338 election must be made not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs. A section 338 election is irrevocable. See §1.338(h)(10)–1T(c)(2) for section 338(h)(10) elections.

(e) Special rules for foreign corpora- tions or DISCs —(1) Elections by certain foreign purchasing corporations —(i) General rule . A qualifying foreign purchasing corporation is not required to file a statement of section 338 election for a qualifying foreign target before the earlier of 3 years after the acquisition date and the 180th day after the close of the purchasing corporation’s taxable year within which a triggering event occurs.

(ii) Qualifying foreign purchasing cor- poration . A purchasing corporation is a qualifying foreign purchasing corpora- tion only if, during the acquisition period of a qualifying foreign target, all the corporations in the purchasing corporation’s affiliated group are foreign corporations that are not subject to United States tax.

(iii) Qualifying foreign target . A target is a qualifying foreign target only if target and its target affiliates are foreign corporations that, during target’s acquisition period, are not subject to United States tax (and will not become subject to United States tax during such period because of a section 338 election). A target affiliate is taken into account for purposes of the preceding sentence only if, during target’s 12-month acquisition period, it is or becomes a member of the affiliated group

January 24, 2000 340 2000–4 I.R.B.

SURY REGULATIONS SECTION 1.338-2T(e)(4). FOR POSSIBLE UNITED STATES FEDERAL INCOME TAX CONSEQUENCES UNDER SECTION 551, 951, 1248, OR 1293 OF THE INTERNAL REVENUE CODE OF 1986 THAT MAY APPLY TO YOU, SEE TREASURY REGULATIONS SECTION 1.338-9(b). YOU MAY BE REQUIRED TO ATTACH THE INFORMATION ATTACHED TO THIS NOTICE TO CERTAIN RETURNS.

(iv) Timing of notice. The notice required by this paragraph (e)(4) must be delivered to the U.S. person on or before the later of the 120th day after the acquisition date of the particular target or the day on which Form 8023 is filed. The notice is considered delivered on the date it is mailed to the proper address (or an address similar enough to complete delivery), unless the date it is mailed cannot be reasonably determined. The date of mailing will be determined under the rules of section 7502. For example, the date of mailing is the date of U.S. postmark or the applicable date recorded or marked by a designated delivery service.

(v) Consequence of failure to comply. A statement of section 338 election is not valid if timely notice is not given to one or more U.S. persons described in this paragraph (e)(4). If the form of notice fails to comply with all requirements of this paragraph (e)(4), the section 338 election is valid, but the waiver rule of §1.338-10T(b)(1) does not apply.

(vi) Good faith effort to comply. The purchasing corporation will be considered to have complied with this paragraph (e)(4), even though it failed to provide notice or provide timely notice to each person described in this paragraph (e)(4), if the Commissioner determines that the purchasing corporation made a good faith effort to identify and provide timely notice to those U.S. persons. §1.338-3T Qualification for the section 338 election (temporary). (a) Scope. This section provides rules on whether certain acquisitions of stock are qualified stock purchases and on other miscellaneous issues under section 338.

(b) Rules relating to qualified stock purchases —(1) Purchasing corporation requirement . An individual cannot make a qualified stock purchase of target. Section 338(d)(3) requires, as a condition of a

that includes the purchasing corporation.

(iv) Triggering event . A triggering event occurs in the taxable year of the qualifying foreign purchasing corporation in which either that corporation or any corporation in its affiliated group becomes subject to United States tax.

(v) Subject to United States tax . For purposes of this paragraph (e)(1), a foreign corporation is considered subject to United States tax—

(A) For the taxable year for which that corporation is required under §1.6012–2(g) (other than §1.6012–2(g)(2)(i)(B)(2)) to file a United States income tax return; or

(B) For the period during which that corporation is a controlled foreign corporation, a passive foreign investment company for which an election under section 1295 is in effect, a foreign investment company, or a foreign corporation the stock ownership of which is described in section 552(a)(2).

(2) Acquisition period . For purposes of this paragraph (e), the term acquisition period means the period beginning on the first day of the 12-month acquisition period and ending on the acquisition date.

(3) Statement of section 338 election may be filed by United States sharehold- ers in certain cases. The United States shareholders (as defined in section 951(b)) of a foreign purchasing corporation that is a controlled foreign corporation (as defined in section 957 (taking into account section 953(c))) may file a statement of section 338 election on behalf of the purchasing corporation if the purchasing corporation is not required under §1.6012–2(g) (other than §1.6012–2(g)(2)(i)(B)(2)) to file a United States income tax return for its taxable year that includes the acquisition date. Form 8023 must be filed as described in the form and its instructions and also must be attached to the Form 5471 (information return with respect to a foreign corporation) filed with respect to the purchasing corporation by each United States shareholder for the purchasing corporation’s taxable year that includes the acquisition date (or, if paragraph (e)(1)(i) of this section applies to the election, for the purchasing corporation’s taxable year within which it becomes a controlled foreign corporation). The provisions of §1.964–1(c) (including §1.964–1(c)(7)) do not apply to an election made by the

United States shareholders.

(4) Notice requirement for U.S. persons holding stock in foreign market —(i) Gen- eral rule. If a target subject to a section 338 election was a controlled foreign corporation, a passive foreign investment company, or a foreign personal holding company at any time during the portion of its taxable year that ends on its acquisition date, the purchasing corporation must deliver written notice of the election (and a copy of Form 8023, its attachments and instructions) to—

(A) Each U.S. person (other than a member of the affiliated group of which the purchasing corporation is a member (the purchasing group member)) that, on the acquisition date of the foreign target, holds stock in the foreign target; and

(B) Each U.S. person (other than a purchasing group member) that sells stock in the foreign target to a purchasing group member during the foreign target’s 12month acquisition period.

(ii) Limitation . The notice requirement of this paragraph (e)(4) applies only where the section 338 election for the foreign target affects income, gain, loss, deduction, or credit of the U.S. person described in paragraph (e)(4)(i) of this section under section 551, 951, 1248, or 1293. (iii) Form of notice . The notice to U.S. persons must be identified prominently as a notice of section 338 election and must—

(A) Contain the name, address, and employer identification number (if any) of, and the country (and, if relevant, the lesser political subdivision) under the laws of which is organized, the purchasing corporation and the relevant target (i.e., target the stock of which the particular U.S. person held or sold under the circumstances described in paragraph (e)(4)(i) of this section);

(B) Identify those corporations as the purchasing corporation and the foreign target, respectively; and

(C) Contain the following declaration (or a substantially similar declaration): THIS DOCUMENT SERVES AS NOTICE OF AN ELECTION UNDER SECTION 338 FOR THE ABOVE CITED FOREIGN TARGET THE STOCK OF WHICH YOU EITHER HELD OR SOLD UNDER THE CIRCUMSTANCES DESCRIBED IN TREA

2000–4 I.R.B. 341 January 24, 2000

Example 3 . (i) On February 1 of Year 1, P acquires 25 percent in value of the R stock from B (the sole shareholder of P). That R stock is not acquired by purchase. See section 338(h)(3)(A)(iii). On that date, R owns 4 of the 100 shares of T stock. On June 1 of Year 1, P purchases an additional 25 percent in value of the R stock, and on January 1 of Year 2, P purchases another 25 percent in value of the R stock. On June 1 of Year 2, R acquires an additional 16 shares of the T stock. On December 1 of Year 2, P purchases 68 shares of the T stock from an unrelated person and 12 of the 20 shares of the T stock held by R. (ii) Of the 12 shares of the T stock purchased by P from R on December 1 of Year 2, 2 of those shares are deemed to have been acquired by P on June 1 of Year 1, the date on which 2 of the 4 shares of the T stock held by R on that date were first considered owned by P under section 318(a)(2)(C) (i.e., 4 ( .5). For purposes of this attribution, the R stock need not be acquired by P by purchase. See section 338(h)(1). (By contrast, the acquisition of the T stock by P from R does not qualify as a purchase unless P has acquired at least 50 percent in value of the R stock by purchase. Section 338(h)(3)(C)(i).) Of the remaining 10 shares of the T stock purchased by P from R on December 1 of Year 2, 1 of those shares is deemed to have been acquired by P on January 1 of Year 2, the date on which an additional 1 share of the 4 shares of the T stock held by R on that date was first considered owned by P under section 318(a)(2)(C) (i.e., (4 ( .75) –2). The remaining 9 shares of the T stock purchased by P from R on December 1 of Year 2, are deemed to have been acquired by P on June 1 of Year 2, the date on which an additional 12 shares of the T stock held by R on that date were first considered owned by P under section 318(a)(2)(C) (i.e., (20 ( .75) –3). Because a qualified stock purchase of T by P is made on December 1 of Year 2, only if all 12 shares of the T stock purchased by P from R on that date are considered acquired during a 12-month period ending on that date (so that, in conjunction with the 68 shares of the T stock P purchased on that date from the unrelated person, 80 of T’s 100 shares are acquired by P during a 12-month period) and because 2 of those 12 shares are considered to have been acquired by P more than 12 months before December 1 of Year 2 (i.e., on June 1 of Year 1), a qualified stock purchase is not made. (Under §1.338–8(j)(2), for purposes of applying the consistency rules, P is treated as making a qualified stock purchase of T if, pursuant to an arrangement, P purchases T stock satisfying the requirements of section 1504(a)(2) over a period of more than 12 months.) Example 4. Assume the same facts as in Example 3, except that on February 1 of Year 1, P acquires 25 percent in value of the R stock by purchase. The result is the same as in Example 3 .

(4) Acquisition date for tiered targets (i) Stock sold in deemed asset sale . If an election under section 338 is made for target, old target is deemed to sell target’s assets and new target is deemed to acquire those assets. Under section 338(h)(3)(B), new target’s deemed purchase of stock of another corporation is a purchase for purposes of section 338(d)(3) on the acquisition date of target. If new target’s deemed purchase causes a qualified stock pur

qualified stock purchase, that a corporation purchase the stock of target. If an individual forms a corporation (new P) to acquire target stock, new P can make a qualified stock purchase of target if new P is considered for tax purposes to purchase the target stock. Facts that may indicate that new P does not purchase the target stock include new P’s merging downstream into target, liquidating, or otherwise disposing of the target stock following the purported qualified stock purchase.

(2) Purchase —(i) Definition . The term purchase has the same meaning as in section 338(h)(3).

(ii) Purchase of target. [Reserved] (iii) Purchase of target affiliate . Stock in a target affiliate acquired by new target in the deemed asset sale of target’s assets is considered purchased if, under general principles of tax law, new target is considered to own stock of the target affiliate meeting the requirements of section 1504(a)(2), notwithstanding that no amount may be allocated to target’s stock in the target affiliate.

(3) Acquisitions of stock from related corporations —(i) In general. Stock acquired by a purchasing corporation from a related corporation (R) is generally not considered acquired by purchase. See section 338(h)(3)(A)(iii).

(ii) Time for testing relationship. For purposes of section 338(h)(3)(A)(iii), a purchasing corporation is treated as related to another person if the relationship specified in section 338(h)(3)(A)(iii) exists—

(A) In the case of a single transaction, immediately after the purchase of Target stock;

(B) In the case of a series of acquisitions otherwise constituting a qualified stock purchase within the meaning of section 338(d)(3), immediately after the last acquisition in such series; and

(C) In the case of a series of transactions effected pursuant to an integrated plan to dispose of Target stock, immediately after the last transaction in such series.

(iii) Cases where section 338(h)(3)(C) applies—acquisitions treated as pur- chases . If section 338(h)(3)(C) applies and the purchasing corporation is treated as acquiring stock by purchase from R, solely for purposes of determining when

the stock is considered acquired, target stock acquired from R is considered to have been acquired by the purchasing corporation on the day on which the purchasing corporation is first considered to own that stock under section 318(a) (other than section 318(a)(4)).

(iv) Examples . The following examples illustrate this paragraph (b)(3):

Example 1 . (i) S is the parent of a group of corporations that are engaged in various businesses. Prior to January 1, Year 1, S decided to discontinue its involvement in one line of business. To accomplish this, S forms a new corporation, Newco, with a nominal amount of cash. Shortly thereafter, on January 1, Year 1, S transfers all the stock of the subsidiary conducting the unwanted business (Target) to Newco in exchange for 100 shares of Newco common stock and a Newco promissory note. Prior to January 1, Year 1, S and Underwriter (U) had entered into a binding agreement pursuant to which U would purchase 60 shares of Newco common stock from S and then sell those shares in an Initial Public Offering (IPO). On January 6, Year 1, the IPO closes.

(ii) Newco’s acquisition of Target stock is one of a series of transactions undertaken pursuant to one integrated plan. The series of transactions ends with the closing of the IPO and the transfer of all the shares of stock in accordance with the agreements. Immediately after the last transaction effected pursuant to the plan, S owns 40 percent of Newco, which does not give rise to a relationship described in section 338(h)(3)(A)(iii). See §1.338–2T(b)(3)(ii)(C). Accordingly, S and Newco are not related for purposes of section 338(h)(3)(A)(iii). (iii) Further, because Newco’s basis in the Target stock is not determined by reference to S’s basis in the Target stock and because the transaction is not an exchange to which section 351, 354, 355, or 356 applies, Newco’s acquisition of the Target stock is a purchase within the meaning of section 338(h)(3).

Example 2 . (i) On January 1 of Year 1, P purchases 75 percent in value of the R stock. On that date, R owns 4 of the 100 shares of T stock. On June 1 of Year 1, R acquires an additional 16 shares of T stock. On December 1 of Year 1, P purchases 70 shares of T stock from an unrelated person and 12 of the 20 shares of T stock held by R.

(ii) Of the 12 shares of T stock purchased by P from R on December 1 of Year 1, 3 of those shares are deemed to have been acquired by P on January 1 of Year 1, the date on which 3 of the 4 shares of T stock held by R on that date were first considered owned by P under section 318(a)(2)(C) (i.e., 4 ( .75). The remaining 9 shares of T stock purchased by P from R on December 1 of Year 1, are deemed to have been acquired by P on June 1 of Year 1, the date on which an additional 12 of the 20 shares of T stock owned by R on that date were first considered owned by P under section 318(a)(2)(C) (i.e., (20 ( .75) -3). Because stock acquisitions by P sufficient for a qualified stock purchase of T occur within a 12-month period (i.e., 3 shares constructively on January 1 of Year 1, 9 shares constructively on June 1 of Year 1, and 70 shares actually on December 1 of Year 1), a qualified stock purchase is made on December 1 of Year 1.

January 24, 2000 342 2000–4 I.R.B.

chase of the other corporation and if a section 338 election is made for the other corporation, the acquisition date for the other corporation is the same as the acquisition date of target. However, the deemed sale and purchase of the other corporation’s assets is considered to take place after the deemed sale and purchase of target’s assets.

(ii) Examples . The following examples illustrate this paragraph (b)(4):

Example 1. A owns all of the T stock. T owns 50 of the 100 shares of X stock. The other 50 shares of X stock are owned by corporation Y, which is unrelated to A, T, or P. On January 1 of Year 1, P makes a qualified stock purchase of T from A and makes a section 338 election for T. On December 1 of Year 1, P purchases the 50 shares of X stock held by Y. A qualified stock purchase of X is made on December 1 of Year 1, because the deemed purchase of 50 shares of X stock by new T because of the section 338 election for T and the actual purchase of 50 shares of X stock by P are treated as purchases made by one corporation. Section 338(h)(8). For purposes of determining whether those purchases occur within a 12month acquisition period as required by section 338(d)(3), T is deemed to purchase its X stock on T’s acquisition date, i.e., January 1 of Year 1.

Example 2 . On January 1 of Year 1, P makes a qualified stock purchase of T and makes a section 338 election for T. On that day, T sells all of the stock of T1 to A. Although T held all of the T1 stock on T’s acquisition date, T is not considered to have purchased the T1 stock because of the section 338 election for T. In order for T to be treated as purchasing the T1 stock, T must hold the T1 stock when T’s deemed asset sale occurs. The deemed asset sale is considered the last transaction of old T at the close of T’s acquisition date. Accordingly, the T1 stock actually disposed of by T on the acquisition date is not included in the deemed asset sale. Thus, T does not make a qualified stock purchase of T1.

(5) Effect of redemptions —(i) General rule . Except as provided in this paragraph (b)(5), a qualified stock purchase is made on the first day on which the percentage ownership requirements of section 338(d)(3) are satisfied by reference to target stock that is both—

(A) Held on that day by the purchasing corporation; and

(B) Purchased by the purchasing corporation during the 12-month period ending on that day.

(ii) Redemptions from persons unre- lated to the purchasing corporation . Target stock redemptions from persons unrelated to the purchasing corporation that occur during the 12-month acquisition period are taken into account as reductions in target’s outstanding stock for purposes of determining whether target stock purchased by the purchasing corporation in

the 12-month acquisition period satisfies the percentage ownership requirements of section 338(d)(3).

(iii) Redemptions from the purchasing corporation or related persons during 12- month acquisition period —(A) General rule . For purposes of the percentage ownership requirements of section 338(d)(3), a redemption of target stock during the 12-month acquisition period from the purchasing corporation or from any person related to the purchasing corporation is not taken into account as a reduction in target’s outstanding stock.

(B) Exception for certain redemptions from related corporations . A redemption of target stock during the 12-month acquisition period from a corporation related to the purchasing corporation is taken into account as a reduction in target’s outstanding stock to the extent that the redeemed stock would have been considered purchased by the purchasing corporation (because of section 338(h)(3)(C)) during the 12-month acquisition period if the redeemed stock had been acquired by the purchasing corporation from the related corporation on the day of the redemption. See paragraph (b)(3) of this section.

(iv) Examples. The following examples illustrate this paragraph (b)(5):

Example 1 . QSP on stock purchase date; re- demption from unrelated person during 12-month period. A owns all 100 shares of T stock. On January 1 of Year 1, P purchases 40 shares of the T stock from A. On July 1 of Year 1, T redeems 25 shares from A. On December 1 of Year 1, P purchases 20 shares of the T stock from A. P makes a qualified stock purchase of T on December 1 of Year 1, because the 60 shares of T stock purchased by P within the 12-month period ending on that date satisfy the 80-percent ownership requirements of section 338(d)(3) (i.e., 60/75 shares), determined by taking into account the redemption of 25 shares.

Example 2. QSP on stock redemption date; re- demption from unrelated person during 12-month pe- riod. The facts are the same as in Example 1, except that P purchases 60 shares of T stock on January 1 of Year 1 and none on December 1 of Year 1. P makes a qualified stock purchase of T on July 1 of Year 1, because that is the first day on which the T stock purchased by P within the preceding 12-month period satisfies the 80-percent ownership requirements of section 338(d)(3) (i.e., 60/75 shares), determined by taking into account the redemption of 25 shares.

Example 3. Redemption from purchasing corpo- ration not taken into account. On December 15 of Year 1, T redeems 30 percent of its stock from P. The redeemed stock was held by P for several years and constituted P’s total interest in T. On December 1 of Year 2, P purchases the remaining T stock from A. P does not make a qualified stock purchase of T on December 1 of Year 2. For purposes of the 80

percent ownership requirements of section 338(d)(3), the redemption of P’s T stock on December 15 of Year 1 is not taken into account as a reduction in T’s outstanding stock.

Example 4. Redemption from related person taken into account. On January 1 of Year 1, P purchases 60 of the 100 shares of X stock. On that date, X owns 40 of the 100 shares of T stock. On April 1 of Year 1, T redeems X’s T stock and P purchases the remaining 60 shares of T stock from an unrelated person. For purposes of the 80-percent ownership requirements of section 338(d)(3), the redemption of the T stock from X (a person related to P) is taken into account as a reduction in T’s outstanding stock. If P had purchased the 40 redeemed shares from X on April 1 of Year 1, all 40 of the shares would have been considered purchased (because of section 338(h)(3)(C)(i)) during the 12-month period ending on April 1 of Year 1 (24 of the 40 shares would have been considered purchased by P on January 1 of Year 1 and the remaining 16 shares would have been considered purchased by P on April 1 of Year 1). See paragraph (b)(3) of this section. Accordingly, P makes a qualified stock purchase of T on April 1 of Year 1, because the 60 shares of T stock purchased by P on that date satisfy the 80-percent ownership requirements of section 338(d)(3) (i.e., 60/60 shares), determined by taking into account the redemption of 40 shares.

(c) Effect of post-acquisition events on eligibility for section 338 election - (1) Post-acquisition elimination of target . (i) The purchasing corporation may make an election under section 338 for target even though target is liquidated on or after the acquisition date. If target liquidates on the acquisition date, the liquidation is considered to occur on the following day and immediately after new target’s deemed purchase of assets. The purchasing corporation may also make an election under section 338 for target even though target is merged into another corporation, or otherwise disposed of by the purchasing corporation provided that, under the facts and circumstances, the purchasing corporation is considered for tax purposes as the purchaser of the target stock.

(ii) The following examples illustrate this paragraph (c)(1):

Example 1. On January 1 of Year 1, P purchases 100 percent of the outstanding common stock of T. On June 1 of Year 1, P sells the T stock to an unrelated person. Assuming that P is considered for tax purposes as the purchaser of the T stock, P remains eligible, after June 1 of Year 1, to make a section 338 election for T that results in a deemed asset sale of T’s assets on January 1 of Year 1.

Example 2 . On January 1 of Year 1, P makes a qualified stock purchase of T. On that date, T owns the stock of T1. On March 1 of Year 1, T sells the T1 stock to an unrelated person. On April 1 of Year 1, P makes a section 338 election for T. Notwithstanding that the T1 stock was sold on March 1 of Year 1, the section 338 election for T on April 1 of Year 1 results in a qualified stock purchase by T of

2000–4 I.R.B. 343 January 24, 2000

T1 on January 1 of Year 1. See paragraph (b)(4)(i) of this section.

(2) Post-acquisition elimination of the purchasing corporation. An election under section 338 may be made for target after the acquisition of assets of the purchasing corporation by another corporation in a transaction described in section 381(a), provided that the purchasing corporation is considered for tax purposes as the purchaser of the target stock. The acquiring corporation in the section 381(a) transaction may make an election under section 338 for target.

(3) Consequences of post-acquisition elimination of target —(i) Scope . The rules of this paragraph (c)(3) apply to the transfer of target assets to the purchasing corporation (or another member of the same affiliated group as the purchasing corporation) (the transferee) following a qualified stock purchase of target stock, if the purchasing corporation does not make a section 338 election for target. Notwithstanding the rules of this paragraph (c)(3), section 354(a) (and so much of section 356 as relates to section 354) cannot apply to any person other than the purchasing corporation or another member of the same affiliated group as the purchasing corporation unless the transfer of target assets is pursuant to a reorganization as determined without regard to this paragraph (c)(3).

(ii) Continuity of interest . By virtue of section 338, in determining whether the continuity of interest requirement of §1.368-1(b) is satisfied on the transfer of assets from target to the transferee, the purchasing corporation’s target stock acquired in the qualified stock purchase represents an interest on the part of a person who was an owner of the target’s business enterprise prior to the transfer that can be continued in a reorganization.

(iii) Control requiremen t. By virtue of section 338, the acquisition of target stock in the qualified stock purchase will not prevent the purchasing corporation from qualifying as a shareholder of the target transferor for the purpose of determining whether, immediately after the transfer of target assets, a shareholder of the transferor is in control of the corporation to which the assets are transferred within the meaning of section 368(a)(1)(D).

(iv) Example . The following example illustrates this paragraph (c)(3):

Example . (i) Facts. P, T, and X are domestic cor

porations. T and X each operate a trade or business. A and K, individuals unrelated to P, own 85 and 15 percent, respectively, of the stock of T. P owns all of the stock of X. The total adjusted basis of T’s property exceeds the sum of T’s liabilities plus the amount of liabilities to which T’s property is subject. P purchases all of A’s T stock for cash in a qualified stock purchase. P does not make an election under section 338(g) with respect to its acquisition of T stock. Shortly after the acquisition date, and as part of the same plan, T merges under applicable state law into X in a transaction that, but for the question of continuity of interest, satisfies all the requirements of section 368(a)(1)(A). In the merger, all of T’s assets are transferred to X. P and K receive X stock in exchange for their T stock. P intends to retain the stock of X indefinitely.

(ii) Status of transfer as a reorganization . By virtue of section 338, for the purpose of determining whether the continuity of interest requirement of §1.368–1(b) is satisfied, P’s T stock acquired in the qualified stock purchase represents an interest on the part of a person who was an owner of T’s business enterprise prior to the transfer that can be continued in a reorganization through P’s continuing ownership of X. Thus, the continuity of interest requirement is satisfied and the merger of T into X is a reorganization within the meaning of section 368(a)(1)(A). Moreover, by virtue of section 338, the requirement of section 368(a)(1)(D) that a target shareholder control the transferee immediately after the transfer is satisfied because P controls X immediately after the transfer. In addition, all of T’s assets are transferred to X in the merger and P and K receive the X stock exchanged therefor in pursuance of the plan of reorganization. Thus, the merger of T into X is also a reorganization within the meaning of section 368(a)(1)(D).

(iii) Treatment of T and X. Under section 361(a), T recognizes no gain or loss in the merger. Under section 362(b), X’s basis in the assets received in the merger is the same as the basis of the assets in T’s hands. X succeeds to and takes into account the items of T as provided in section 381.

(iv) Treatment of P . By virtue of section 338, the transfer of T assets to X is a reorganization. Pursuant to that reorganization, P exchanges its T stock solely for stock of X, a party to the reorganization. Because P is the purchasing corporation, section 354 applies to P’s exchange of T stock for X stock in the merger of T into X. Thus, P recognizes no gain or loss on the exchange. Under section 358, P’s basis in the X stock received in the exchange is the same as the basis of P’s T stock exchanged therefor.

(v) Treatment of K . Because K is not the purchasing corporation (or an affiliate thereof), section 354 cannot apply to K’s exchange of T stock for X stock in the merger of T into X unless the transfer of T’s assets is pursuant to a reorganization as determined without regard to this paragraph (c)(3). Under general principles of tax law applicable to reorganizations, the continuity of interest requirement is not satisfied because P’s stock purchase and the merger of T into X are pursuant to an integrated transaction in which A, the owner of 85 percent of the stock of T, received solely cash in exchange for A’s T stock. See, e.g., Yoc Heating v. Commissioner, 61 T.C. 168 (1973); Kass v. Commissioner, 60 T.C. 218 (1973), aff’d, 491 F.2d 749 (3d Cir. 1974). Thus, the requisite continuity of interest under

§1.368–1(b) is lacking and section 354 does not apply to K’s exchange of T stock for X stock. K recognizes gain or loss, if any, pursuant to section 1001(c) with respect to its T stock.

§§1.338–4 and 1.338–5 [Redesignated as §§1.338–8 and 1.338–9]

Par. 5. Sections 1.338–4 and 1.338–5 are redesignated as §§1.338–8 and 1.338–9, respectively. Par. 6. New §§1.338–4T and 1.338–5T are added to read as follows: §1.338–4T Aggregate deemed sale price; various aspects of taxation of the deemed asset sale (temporary).

(a) Scope . This section provides rules under section 338(a)(1) to determine the aggregate deemed sale price (ADSP) for target. ADSP is the amount for which old target is deemed to have sold all of its assets in the deemed asset sale. ADSP is allocated among target’s assets in accordance with §1.338–6T to determine the amount for which each asset is deemed to have been sold. When an increase or decrease with respect to an element of ADSP is required, under general principles of tax law, after the close of new target’s first taxable year, redetermined ADSP is allocated among target’s assets in accordance with §1.338–7T. This section also provides rules regarding the recognition of gain or loss on the deemed sale of target affiliate stock. Notwithstanding section 338(h)(6)(B)(ii), stock held by a target affiliate in a foreign corporation or in a corporation that is a DISC or that is described in section 1248(e) is not excluded from the operation of section 338.

(b) Determination of ADSP —(1) Gen- eral rule . ADSP is the sum of—

(i) The grossed-up amount realized on the sale to the purchasing corporation of the purchasing corporation’s recently purchased target stock (as defined in section 338(b)(6)(A)); and (ii) The liabilities of old target. (2) Time and amount of ADSP —(i) Original determination. ADSP is initially determined at the beginning of the day after the acquisition date of target. General principles of tax law apply in determining the timing and amount of the elements of ADSP.

(ii) Redetermination of ADSP . ADSP is redetermined at such time and in such amount as an increase or decrease would be required, under general principles of tax law, for the elements of ADSP. For exam

January 24, 2000 344 2000–4 I.R.B.

into account the tax liability for the deemed sale gain when a section 338(h)(10) election is made for a target S corporation because the S corporation shareholders bear that liability. However, if a target S corporation is subject to a tax under section 1374 or 1375, the liability for tax imposed by those sections is a liability of target taken into account in ADSP (unless the S corporation shareholders expressly assume that liability).

(2) Time and amount of liabilities. The time for taking into account liabilities of old target in determining ADSP and the amount of the liabilities taken into account is determined as if old target had sold its assets to an unrelated person for consideration that included the unrelated person’s assumption of or taking subject to the liabilities. For example, if no amount of a target liability is properly taken into account in amount realized as of the beginning of the day after the acquisition date, the liability is not initially taken into account in determining ADSP (although it may be taken into account at some later date). As a further example, an increase or decrease in a liability that does not affect the amount of old target’s basis, deductions, or noncapital nondeductible items arising from the incurrence of the liability is not taken into account in redetermining ADSP.

(3) Interaction with deemed sale gain. Though deemed sale gain increases or decreases ADSP by creating or reducing a tax liability, the amount of the tax liability itself is a function of the size of the deemed sale gain. Thus, the determination of ADSP may require trial and error computations.

(e) Calculation of deemed sale gain . Deemed sale gain on each asset is computed by reference to the ADSP allocated to that asset.

(f) Other rules apply in determining ADSP. ADSP may not be applied in such a way as to contravene other applicable rules. For example, a capital loss cannot be applied to reduce ordinary income in calculating the tax liability on the deemed sale for purposes of determining ADSP.

(g) Examples . The following examples illustrate this section. For purposes of the examples in this paragraph (g), unless otherwise stated, T is a calendar year taxpayer that files separate returns and that has no loss, tax credit, or other carryovers to Year

ple, ADSP is redetermined because of an increase or decrease in the amount realized for recently purchased stock or because liabilities not originally taken into account in determining ADSP are subsequently taken into account. An increase or decrease to one element of ADSP may cause an increase or decrease to the other element of ADSP. For example, if an increase in the amount realized for recently purchased stock of target is taken into account after the acquisition date, any increase in the tax liability of target for the deemed sale gain is also taken into account when ADSP is redetermined. Increases or decreases with respect to the elements of ADSP that are taken into account before the close of new target’s first taxable year are taken into account for purposes of determining ADSP and the deemed sale gain as if they had been taken into account at the beginning of the day after the acquisition date. Increases or decreases with respect to the elements of ADSP that are taken into account after the close of new target’s first taxable year result in the reallocation of ADSP among target’s assets under §1.338–7T.

(iii) Example . The following example illustrates this paragraph (b)(2):

Example. In Year 1, T, a manufacturer, purchases a customized delivery truck from X with purchase money indebtedness having a stated principal amount of $100,000. P acquires all of the stock of T in Year 3 for $700,000 and makes a section 338 election for T. Assume T has no liabilities other than its purchase money indebtedness to X. In Year 4, when T is neither insolvent nor in a title 11 case, T and X agree to reduce the amount of the purchase money indebtedness to $80,000. Assume further that the reduction would be a purchase price reduction under section 108(e)(5). T and X’s agreement to reduce the amount of the purchase money indebtedness would not, under general principles of tax law that would apply if the deemed asset sale had actually occurred, change the amount of liabilities of old target taken into account in determining its amount realized. Accordingly, ADSP is not redetermined at the time of the reduction. See §1.338–5T(b)(2)(iii) Example 1 for the effect on AGUB.

(c) Grossed-up amount realized on the sale to the purchasing corporation of the purchasing corporation’s recently pur- chased target stock —(1) Determination of amount . The grossed-up amount realized on the sale to the purchasing corporation of the purchasing corporation’s recently purchased target stock is an amount equal to—

(i) The amount realized on the sale to the purchasing corporation of the purchasing corporation’s recently purchased target stock determined as if old target

were the selling shareholder and the installment method were not available and determined without regard to the selling costs taken into account in paragraph (c)(1)(iii) of this section;

(ii) Divided by the percentage of target stock (by value, determined on the acquisition date) attributable to that recently purchased target stock;

(iii) Less the selling costs incurred by the selling shareholders in connection with the sale to the purchasing corporation of the purchasing corporation’s recently purchased target stock that reduce their amount realized on the sale of the stock (e.g., brokerage commissions and any similar costs to sell the stock).

(2) Example . The following example illustrates this paragraph (c):

Example . T has two classes of stock outstanding, voting common stock and preferred stock not taken into account for purposes of section 1504(a)(2). On March 1 of Year 1, P purchases 40 percent of the outstanding T stock from S1 for $500, 20 percent of the outstanding T stock from S2 for $225, and 20 percent of the outstanding T stock from S3 for $275. On that date, the fair market value of all the T voting common stock is $1,250 and the preferred stock $750. S1, S2, and S3 respectively incur $40, $35, and $25 of selling costs. S1 continues to own the remaining 20 percent of the outstanding T stock. The grossed-up amount realized on the sale to P of P’s recently purchased T stock is calculated as follows: The total amount realized (without regard to selling costs) is $1,000 (500 + 225 + 275). The percentage of T stock by value on the acquisition date attributable to the recently purchased T stock is 50% (1,000/(1,250 + 750)). The selling costs are $100 (40 + 35 + 25). The grossed-up amount realized is $1,900 (1,000/.5 å100).

(d) Liabilities of old target —(1) In gen- eral. The liabilities of old target are the liabilities of target (and the liabilities to which target’s assets are subject) as of the beginning of the day after the acquisition date (other than liabilities that were neither liabilities of old target nor liabilities to which old target’s assets were subject). In order to be taken into account in ADSP, a liability must be a liability of target that is properly taken into account in amount realized under general principles of tax law that would apply if old target had sold its assets to an unrelated person for consideration that included that person’s assumption of, or taking subject to, the liability. Thus, ADSP takes into account both tax credit recapture liability arising because of the deemed asset sale and the tax liability for the deemed sale gain unless the tax liability is borne by some person other than the target. For example, ADSP would not take

2000–4 I.R.B. 345 January 24, 2000

1. Depreciation for Year 1 is not taken into account. T has no liabilities other than the Federal income tax liability resulting from the deemed asset sale, and the T shareholders have no selling costs. Assume that T’s tax rate for any ordinary income or net capital gain resulting from the deemed sale of assets is 34 percent and that any capital loss is offset by capital gain. On July 1 of Year 1, P purchases all of the stock of T and makes a section 338 election for T. The examples are as follows:

Example 1. One class . (i) On July 1 of Year 1, T’s only asset is an item of section 1245 property with an adjusted basis to T of $50,400, a recomputed basis of $80,000, and a fair market value of $100,000. P purchases all of the T stock for $75,000, which also equals the amount realized for the stock determined as if old target were the selling shareholder.

(ii) ADSP is determined as follows (In the following formula, G is the grossed-up amount realized on the sale to P of P’s recently purchased T stock, L is T’s liabilities other than T’s tax liability for the deemed sale gain, TR is the applicable tax rate, and B is the adjusted basis of the asset deemed sold):

ADSP = G + L + TR x (ADSP - B) ADSP = ($75,000/1) + $0 + .34 x (ADSP $50,400) ADSP = $75,000 + .34ADSP - $17,136 .66ADSP = $57,864 ADSP = $87,672.72 (iii) Because ADSP for T ($87,672.72) does not exceed the fair market value of T’s asset ($100,000), a Class V asset, T’s entire ADSP is allocated to that asset. Thus, T has deemed sale gain of $37,272.72 (consisting of $29,600 of ordinary income and $7,672.72 of capital gain).

(iv) The facts are the same as in paragraph (i) of this Example 1, except that on July 1 of Year 1, P purchases only 80 of the 100 shares of T stock for $60,000. The grossed-up amount realized on the

sale to P of P’s recently purchased T stock (G) is $75,000 ($60,000/.8). Consequently, ADSP and deemed sale gain are the same as in paragraphs (ii) and (iii) of this Example 1.

(v) The facts are the same as in paragraph (i) of this Example 1, except that T also has goodwill (a Class VII asset) with an appraised value of $10,000. The results are the same as in paragraphs (ii) and (iii) of this Example 1. Because ADSP does not exceed the fair market value of the Class V asset, no amount is allocated to the Class VII asset (goodwill).

Example 2. More than one class. (i) P purchases all of the T stock for $140,000, which also equals the amount realized for the stock determined as if old target were the selling shareholder. On July 1 of Year 1, T has liabilities (not including the tax liability for the deemed sale gain) of $50,000, cash (a Class I asset) of $10,000, actively traded securities (a Class II asset) with a basis of $4,000 and a fair market value of $10,000, goodwill (a Class VII asset) with a basis of $3,000, and the following Class V assets:

Asset Basis FMV Ratio of asset fmv

to total Class V

fmv

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 5,000 $ 35,000 .14

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10,000 50,000 .20

Equipment A (Recomputed basis $80,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5,000 90,000 .36

Equipment B (Recomputed basis $20,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10,000 75,000 .30

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 30,000 $ 250,000 1.00

(ii) ADSP exceeds $20,000. Thus, $10,000 of ADSP is allocated to the cash and $10,000 to the actively traded securities. The amount allocated to an asset (other than a Class VII asset) cannot exceed its fair market value (however, the fair market value of any property subject to nonrecourse indebtedness is treated as being not less than the amount of such indebtedness; see §1.338–6T(a)(2)). See §1.338–6T(c)(1) (relating to fair market value limitation).

(iii) The portion of ADSP allocable to the Class V assets is preliminarily determined as follows (in the formula, the amount allocated to the Class I assets is referred to as I and the amount allocated to the Class

II assets as II):

ADSPV = (G - (I + II)) + L + TR ( [(II - BII) + (ADSPV - BV)] ADSPV = ($140,000 - ($10,000 + $10,000)) + $50,000 + .34 ( [($10,000 - $4,000) + (ADSPV ($5,000 + $10,000 + $5,000 + $10,000))] ADSPV = $161,840 + .34 ADSPV .66 ADSPV = $161,840 ADSPV = $245,212.12 (iv) Because, under the preliminary calculations of ADSP, the amount to be allocated to the Class I, II, III, IV, V, and VI assets does not exceed their aggregate fair market value, no ADSP amount is allocated to goodwill. Accordingly, the deemed sale of the good

will results in a capital loss of $3,000. The portion of ADSP allocable to the Class V assets is finally determined by taking into account this loss as follows:

ADSPV = (G å (I + II)) + L + TR ( [(II å BII) + (ADSPV å BV) + (ADSPVII å BVII)] ADSPV = ($140,000 å ($10,000 + $10,000)) + $50,000 + .34 ( [($10,000 å $4,000) + (ADSPV å $30,000) + ($0 å $3,000)] ADSPV = $160,820 + .34 ADSPV .66 ADSPV = $160,820 ADSPV = $243,666.67 (v) The allocation of ADSPV among the Class V assets is in proportion to their fair market values, as follows:

Asset ADSP Gain

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 34,113.33 $ 29,113.33

(capital gain)

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48,733.34 38,733.34

(capital gain)

Equipment A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87,720.00 82,720.00

(75,000 ordinary income

7,720 capital gain)

Equipment B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .73,100.00 63,100.00

(10,000 ordinary income

53,100 capital gain)

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 243,666.67 $ 213,666.67

January 24, 2000 346 2000–4 I.R.B.

Example 3. More than one class. (i) The facts are the same as in Example 2, except that P purchases the T stock for $150,000, rather than $140,000. The amount realized for the stock determined as if old target were the selling shareholder is also $150,000.

(ii) As in Example 2, ADSP exceeds $20,000. Thus, $10,000 of ADSP is allocated to the cash and $10,000 to the actively traded securities.

(iii) The portion of ADSP allocable to the Class V assets as preliminarily determined under the formula set forth in paragraph (iii) of Example 2 is $260,363.64. The amount allocated to the Class V assets cannot exceed their aggregate fair market value ($250,000). Thus, preliminarily, the ADSP amount allocated to Class V assets is $250,000.

(iv) Based on the preliminary allocation, the ADSP is determined as follows (in the formula, the amount allocated to the Class I assets is referred to as I, the amount allocated to the Class II assets as II, and the amount allocated to the Class V assets as V):

ADSP = G + L + TR ( [(II - BII) + (V - BV) + (ADSP - (I + II + V+ BVII))] ADSP = $150,000 + $50,000 + .34 ( [($10,000 $4,000) + ($250,000 - $30,000) + (ADSP ($10,000 + $10,000 + $250,000 + $3,000))] ADSP = $200,000 + .34ADSP - $15,980 .66ADSP = $184,020 ADSP = $278,818.18 (v) Because ADSP as determined exceeds the aggregate fair market value of the Class I, II, III, IV, V, and VI assets, the $250,000 amount preliminarily allocated to the Class V assets is appropriate. Thus, the amount of ADSP allocated to Class V assets equals their aggregate fair market value ($250,000), and the allocated ADSP amount for each Class V asset is its fair market value. Further, because there are no Class VI assets, the allocable ADSP amount for the Class VII asset (goodwill) is $8,818.18 (the excess of ADSP over the aggregate ADSP amounts for the Class I, II, III, IV, V and VI assets).

Example 4. Amount allocated to T1 stock . (i) The facts are the same as in Example 2, except that T owns all of the T1 stock (instead of the building), and T1’s only asset is the building. The T1 stock and the building each have a fair market value of $50,000, and the building has a basis of $10,000. A section 338 election is made for T1 (as well as T), and T1 has no liabilities other than the tax liability for the deemed sale gain. T is the common parent of a consolidated group filing a final consolidated return described in §1.338–10T(a)(1).

(ii) ADSP exceeds $20,000. Thus, $10,000 of ADSP is allocated to the cash and $10,000 to the actively traded securities.

(iii) Because T does not recognize any gain on the deemed sale of the T1 stock under paragraph (h)(2) of this section, appropriate adjustments must be made to reflect accurately the fair market value of the T and T1 assets in determining the allocation of ADSP among T’s Class V assets (including the T1 stock). In preliminarily calculating ADSPV in this case, the T1 stock can be disregarded and, because T owns all of the T1 stock, the T1 asset can be treated as a T asset. Under this assumption, ADSPV is $243,666.67. See paragraph (iv) of Ex- ample 2 .

(iv) Because the portion of the preliminary ADSP allocable to Class V assets ($243,666.67) does not exceed their fair market value ($250,000), no amount is

allocated to Class VII assets for T. Further, this amount ($243,666.67) is allocated among T’s Class V assets in proportion to their fair market values. See paragraph (v) of Example 2 . Tentatively, $48,733.34 of this amount is allocated to the T1 stock.

(v) The amount tentatively allocated to the T1 stock, however, reflects the tax incurred on the deemed sale of the T1 asset equal to $13,169.34 (.34 ( ($48,733.34 å $10,000)). Thus, the ADSP allocable to the Class V assets of T, and the ADSP allocable to the T1 stock, as preliminarily calculated, each must be reduced by $13,169.34. Consequently, these amounts, respectively, are $230,497.33 and $35,564.00. In determining ADSP for T1, the grossed-up amount realized on the deemed sale to new T of new T’s recently purchased T1 stock is $35,564.00.

(vi) The facts are the same as in paragraph (i) of this Example 4, except that the T1 building has a $12,500 basis and a $62,500 value, all of the outstanding T1 stock has a $62,500 value, and T owns 80 percent of the T1 stock. In preliminarily calculating ADSPV, the T1 stock can be disregarded but, because T owns only 80 percent of the T1 stock, only 80 percent of T1 asset basis and value should be taken into account in calculating T’s ADSP. By taking into account 80 percent of these amounts, the remaining calculations and results are the same as in paragraphs (ii), (iii), (iv), and (v) of this Example 4, except that the grossed-up amount realized on the sale of the recently purchased T1 stock is $44,455.00 ($35,564.00/0.8).

(h) Deemed sale of target affiliate stock (1) Scope . This paragraph (h) prescribes rules relating to the treatment of gain or loss realized on the deemed sale of stock of a target affiliate when a section 338 election (but not a section 338(h)(10) election) is made for the target affiliate. For purposes of this paragraph (h), the definition of domestic corporation in §1.338–2T(c)(9) is applied without the exclusion therein for DISCs, corporations described in section 1248(e), and corporations to which an election under section 936 applies.

(2) In general . Except as otherwise provided in this paragraph (h), if a section 338 election is made for target, target recognizes no gain or loss on the deemed sale of stock of a target affiliate having the same acquisition date and for which a section 338 election is made if—

(i) Target directly owns stock in the target affiliate satisfying the requirements of section 1504(a)(2);

(ii) Target and the target affiliate are members of a consolidated group filing a final consolidated return described in §1.338-10T(a)(1); or

(iii) Target and the target affiliate file a combined return under §1.338–10T(a)(4).

(3) Deemed sale of foreign target affili- ate by a domestic target. A domestic target recognizes gain or loss on the deemed

sale of stock of a foreign target affiliate. For the proper treatment of such gain or loss, see, e.g., sections 1246, 1248, 1291 et seq., and 338(h)(16) and §1.338–9.

(4) Deemed sale producing effectively connected income. A foreign target recognizes gain or loss on the deemed sale of stock of a foreign target affiliate to the extent that such gain or loss is effectively connected (or treated as effectively connected) with the conduct of a trade or business in the United States.

(5) Deemed sale of insurance company target affiliate electing under section 953(d) . A domestic target recognizes gain (but not loss) on the deemed sale of stock of a target affiliate that has in effect an election under section 953(d) in an amount equal to the lesser of the gain realized or the earnings and profits described in section 953(d)(4)(B). (6) Deemed sale of DISC target affiliate. A foreign or domestic target recognizes gain (but not loss) on the deemed sale of stock of a target affiliate that is a DISC or a former DISC (as defined in section 992(a)) in an amount equal to the lesser of the gain realized or the amount of accumulated DISC income determined with respect to such stock under section 995(c). Such gain is included in gross income as a dividend as provided in sections 995(c)(2) and 996(g).

(7) Anti-stuffing rule . If an asset the adjusted basis of which exceeds its fair market value is contributed or transferred to a target affiliate as transferred basis property (within the meaning of section 7701(a)(43)) and a purpose of such transaction is to reduce the gain (or increase the loss) recognized on the deemed sale of such target affiliate’s stock, the gain or loss recognized by target on the deemed sale of stock of the target affiliate is determined as if such asset had not been contributed or transferred.

(8) Examples . The following examples illustrate this paragraph (h):

Example 1 . (i) P makes a qualified stock purchase of T and makes a section 338 election for T. T’s sole asset, all of the T1 stock, has a basis of $50 and a fair market value of $150. T’s deemed purchase of the T1 stock results in a qualified stock purchase of T1 and a section 338 election is made for T1. T1’s assets have a basis of $50 and a fair market value of $150.

(ii) T realizes $100 of gain on the deemed sale of the T1 stock, but the gain is not recognized because T directly owns stock in T1 satisfying the requirements of section 1504(a)(2) and a section 338 election is made for T1.

(iii) T1 recognizes gain of $100 on the deemed sale of its assets.

2000–4 I.R.B. 347 January 24, 2000

taken into account before the close of new target’s first taxable year are taken into account for purposes of determining AGUB and the basis of target’s assets as if they had been taken into account at the beginning of the day after the acquisition date. Increases or decreases with respect to the elements of AGUB that are taken into account after the close of new target’s first taxable year result in the reallocation of AGUB among target’s assets under §1.338–7T.

(iii) Examples. The following examples illustrate this paragraph (b)(2):

Example 1 . In Year 1, T, a manufacturer, purchases a customized delivery truck from X with purchase money indebtedness having a stated principal amount of $100,000 . P acquires all of the stock of T in Year 3 for $700,000 and makes a section 338 election for T. Assume T has no liabilities other than its purchase money indebtedness to X. In Year 4, when T is neither insolvent nor in a title 11 case, T and X agree to reduce the amount of the purchase money indebtedness to $80,000. Assume that the reduction would be a purchase price reduction under section 108(e)(5). T and X’s agreement to reduce the amount of the purchase money indebtedness would, under general principles of tax law that would apply if the deemed asset sale had actually occurred, change the amount of liabilities of old target taken into account in determining its basis. Accordingly, AGUB is redetermined at the time of the reduction. See paragraph (e)(2) of this section. Thus the purchase price reduction affects the basis of the truck only indirectly, through the mechanism of §§1.338–6T and 1.338–7T. See §1.338–4T(b)(2)(iii) Example for the effect on ADSP.

Example 2. T, an accrual basis taxpayer, is a chemical manufacturer. In Year 1, T is obligated to remediate environmental contamination at the site of one of its plants. Assume that all the events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy but economic performance has not occurred with respect to the liability within the meaning of section 461(h). P acquires all of the stock of T in Year 1 and makes a section 338 election for T. Assume that, if a corporation unrelated to T had actually purchased T’s assets and assumed T’s obligation to remediate the contamination, the corporation would not satisfy the economic performance requirements until Year 5. Under section 461(h), the assumed liability would not be treated as incurred and taken into account in basis until that time. The incurrence of the liability in Year 5 under the economic performance rules is an increase in the amount of liabilities properly taken into account in basis and results in the redetermination of AGUB. (Respecting ADSP, compare §1.461–4(d)(5), which provides that economic performance occurs for old T as the amount of the liability is properly taken into account in amount realized on the deemed asset sale. Thus ADSP is not redetermined when new T satisfies the economic performance requirements.)

(c) Grossed-up basis of recently pur- chased stock. The purchasing corporation’s grossed-up basis of recently pur

Example 2. The facts are the same as in Example 1, except that P does not make a section 338 election for T1. Because a section 338 election is not made for T1, the $100 gain realized by T on the deemed sale of the T1 stock is recognized.

Example 3 . (i) P makes a qualified stock purchase of T and makes a section 338 election for T. T owns all of the stock of T1 and T2. T’s deemed purchase of the T1 and T2 stock results in a qualified stock purchase of T1 and T2 and section 338 elections are made for T1 and T2. T1 and T2 each own 50 percent of the vote and value of T3 stock. The deemed purchases by T1 and T2 of the T3 stock result in a qualified stock purchase of T3 and a section 338 election is made for T3. T is the common parent of a consolidated group and all of the deemed asset sales are reported on the T group’s final consolidated return. See §1.338–10T(a)(1).

(ii) Because T, T1, T2 and T3 are members of a consolidated group filing a final consolidated return, no gain or loss is recognized by T, T1 or T2 on their respective deemed sales of target affiliate stock.

Example 4. (i) T’s sole asset, all of the FT1 stock, has a basis of $25 and a fair market value of $150. FT1’s sole asset, all of the FT2 stock, has a basis of $75 and a fair market value of $150. FT1 and FT2 each have $50 of accumulated earnings and profits for purposes of section 1248(c) and (d). FT2’s assets have a basis of $125 and a fair market value of $150, and their sale would not generate subpart F income under section 951. The sale of the FT2 stock or assets would not generate income effectively connected with the conduct of a trade or business within the United States. FT1 does not have an election in effect under section 953(d) and neither FT1 nor FT2 is a passive foreign investment company.

(ii) P makes a qualified stock purchase of T and makes a section 338 election for T. T’s deemed purchase of the FT1 stock results in a qualified stock purchase of FT1 and a section 338 election is made for FT1. Similarly, FT1’s deemed purchase of the FT2 stock results in a qualified stock purchase of FT2 and a section 338 election is made for FT2.

(iii) T recognizes $125 of gain on the deemed sale of the FT1 stock under paragraph (h)(3) of this section. FT1 does not recognize $75 of gain on the deemed sale of the FT2 stock under paragraph (h)(2) of this section. FT2 recognizes $25 of gain on the deemed sale of its assets. The $125 gain T recognizes on the deemed sale of the FT1 stock is included in T’s income as a dividend under section 1248, because FT1 and FT2 have sufficient earnings and profits for full recharacterization ($50 of accumulated earnings and profits in FT1, $50 of accumulated earnings and profits in FT2, and $25 of deemed sale earnings and profits in FT2). §1.338–9(b). For purposes of sections 901 through 908, the source and foreign tax credit limitation basket of $25 of the recharacterized gain on the deemed sale of the FT1 stock is determined under section 338(h)(16). §1.338–5T Adjusted grossed-up basis (temporary).

(a) Scope. This section provides rules under section 338(b) to determine the adjusted grossed-up basis (AGUB) for target. AGUB is the amount for which new target is deemed to have purchased all of its assets in the deemed purchase under

section 338(a)(2). AGUB is allocated among target’s assets in accordance with §1.338–6T to determine the price at which the assets are deemed to have been purchased. When an increase or decrease with respect to an element of AGUB is required, under general principles of tax law, after the close of new target’s first taxable year, redetermined AGUB is allocated among target’s assets in accordance with §1.338–7T.

(b) Determination of AGUB —(1) Gen- eral rule . AGUB is the sum of—

(i) The grossed-up basis in the purchasing corporation’s recently purchased target stock;

(ii) The purchasing corporation’s basis in nonrecently purchased target stock; and

(iii) The liabilities of new target. (2) Time and amount of AGUB —(i) Original determination. AGUB is initially determined at the beginning of the day after the acquisition date of target. General principles of tax law apply in determining the timing and amount of the elements of AGUB.

(ii) Redetermination of AGUB . AGUB is redetermined at such time and in such amount as an increase or decrease would be required, under general principles of tax law, with respect to an element of AGUB. For example, AGUB is redetermined because of an increase or decrease in the amount paid or incurred for recently purchased stock or nonrecently purchased stock or because liabilities not originally taken into account in determining AGUB are subsequently taken into account. An increase or decrease to an element of ADSP may cause an increase or decrease to an element of AGUB. For example, if an increase in the amount realized for recently purchased stock of target is taken into account after the acquisition date, any increase in tax liability of target for the deemed sale gain is also taken into account when AGUB is redetermined. An increase or decrease to one element of AGUB may also cause an increase or decrease to another element of AGUB. For example, if there is an increase in the amount paid or incurred for recently purchased stock after the acquisition date, any increase in the basis of nonrecently purchased stock because a gain recognition election was made is also taken into account when AGUB is redetermined. Increases or decreases with respect to the elements of AGUB that are

January 24, 2000 348 2000–4 I.R.B.

chased target stock (as defined in section 338(b)(6)(A)) is an amount equal to— (1) The purchasing corporation’s basis in recently purchased target stock at the beginning of the day after the acquisition date determined without regard to the acquisition costs taken into account in paragraph (c)(3) of this section;

(2) Multiplied by a fraction, the numerator of which is 100 percent minus the percentage of target stock (by value, determined on the acquisition date) attributable to the purchasing corporation’s nonrecently purchased target stock, and the denominator of which is the percentage of target stock (by value, determined on the acquisition date) attributable to the purchasing corporation’s recently purchased target stock;

(3) Plus the acquisition costs the purchasing corporation incurred in connection with its purchase of the recently purchased stock that are capitalized in the basis of such stock (e.g., brokerage commissions and any similar costs incurred by the purchasing corporation to acquire the stock).

(d) Basis of nonrecently purchased stock; gain recognition election —(1) No gain recognition election . In the absence of a gain recognition election under section 338(b)(3) and this section, the purchasing corporation retains its basis in the nonrecently purchased stock.

(2) Procedure for making gain recogni- tion election . A gain recognition election may be made for nonrecently purchased stock of target (or a target affiliate) only if a section 338 election is made for target (or the target affiliate). The gain recognition election is made by attaching a gain recognition statement to a timely filed Form 8023 for target. The gain recognition statement must contain the information specified in the form and its instructions. The gain recognition election is irrevocable. If a section 338(h)(10) election is made for target, see §1.338(h)(10)–1T(d)(1) (providing that the purchasing corporation is automatically deemed to have made a gain recognition election for its nonrecently purchased T stock).

(3) Effect of gain recognition election —(i) In general . If the purchasing corporation makes a gain recognition election, then for all purposes of the Internal Revenue Code—

(A) The purchasing corporation is treated as if it sold on the acquisition date the nonrecently purchased target stock for the basis amount determined under paragraph (d)(3)(ii) of this section; and

(B) The purchasing corporation’s basis on the acquisition date in nonrecently purchased target stock immediately following the deemed sale in paragraph (d)(3)(i)(A) of this section is the basis amount.

(ii) Basis amount . The basis amount is equal to the amount in paragraph (c)(1) of this section (the purchasing corporation’s basis in recently purchased target stock at the beginning of the day after the acquisition date determined without regard to the acquisition costs taken into account in paragraph (c)(3) of this section) multiplied by a fraction the numerator of which is the percentage of target stock (by value, determined on the acquisition date) attributable to the purchasing corporation’s nonrecently purchased target stock and the denominator of which is 100 percent minus the numerator amount. Thus, if target has a single class of outstanding stock, the purchasing corporation’s basis in each share of nonrecently purchased target stock after the gain recognition election is equal to the average price per share of the purchasing corporation’s recently purchased target stock.

(iii) Losses not recognized. Only gains (unreduced by losses) on the nonrecently purchased target stock are recognized.

(iv) Stock subject to election . The gain recognition election applies to—

(A) All nonrecently purchased target stock; and

(B) Any nonrecently purchased stock in a target affiliate having the same acquisition date as target if such target affiliate stock is held by the purchasing corporation on such date.

(e) Liabilities of new target —(1) In general . The liabilities of new target are the liabilities of target (and the liabilities to which target’s assets are subject) as of the beginning of the day after the acquisition date (other than liabilities that were neither liabilities of old target nor liabilities to which old target’s assets were subject). In order to be taken into account in AGUB, a liability must be a liability of target that is properly taken into account in basis under general principles of tax law that would apply if new target had ac

quired its assets from an unrelated person for consideration that included the assumption of, or taking subject to, the liability. See §1.338–4T(d)(1) for examples of when tax liabilities are considered liabilities assumed by new target.

(2) Time and amount of liabilities . The time for taking into account liabilities of old target in determining AGUB and the amount of the liabilities taken into account is determined as if new target had acquired its assets from an unrelated person for consideration that included the assumption of, or taking subject to, the liabilities. For example, an increase or decrease in a liability that does not affect the amount of new target’s basis arising from the assumption of, or taking subject to, the liability is not taken into account in redetermining AGUB.

(3) Interaction with deemed sale gain . See §1.338–4T(d)(3).

(f) Adjustments by the Internal Revenue Service . In connection with the examination of a return, the District Director may increase (or decrease) AGUB under the authority of section 338(b)(2) and allocate such amounts to target’s assets under the authority of section 338(b)(5) so that AGUB and the basis of target’s assets properly reflect the cost to the purchasing corporation of its interest in target’s assets. Such items may include distributions from target to the purchasing corporation, capital contributions from the purchasing corporation to target during the 12-month acquisition period, or acquisitions of target stock by the purchasing corporation after the acquisition date from minority shareholders.

(g) Examples . The following examples illustrate this section. For purposes of the examples in this paragraph (g), T has no liabilities other than the tax liability for the deemed sale gain, T shareholders incur no costs in selling the T stock, and P incurs no costs in acquiring the T stock. The examples are as follows:

Example 1. (i) Before July 1 of Year 1, P purchases 10 of the 100 shares of T stock for $5,000. On July 1 of Year 2, P purchases 80 shares of T stock for $60,000 and makes a section 338 election for T. As of July 1 of Year 2, T’s only asset is raw land with an adjusted basis to T of $50,400 and a fair market value of $100,000. T has no loss or tax credit carryovers to Year 2. T’s marginal tax rate for any ordinary income or net capital gain resulting from the deemed asset sale is 34 percent. The 10 shares purchased before July 1 of Year 1 constitute nonrecently purchased T stock with respect to P’s qualified stock

2000–4 I.R.B. 349 January 24, 2000

ately realize ordinary income in an amount equal to such excess. The amount of ADSP or AGUB remaining after the reduction is to be allocated to the remaining acquisition date assets.

(2) Other assets —(i) In general . Subject to the limitations and other rules of paragraph (c) of this section, ADSP and AGUB (as reduced by the amount of Class I assets) are allocated among Class II acquisition date assets of target in proportion to the fair market values of such Class II assets at such time, then among Class III assets so held in such proportion, then among Class IV assets so held in such proportion, then among Class V assets so held in such proportion, then among Class VI assets so held in such proportion, and finally to Class VII assets.

(ii) Class II assets. Class II assets are actively traded personal property within the meaning of section 1092(d)(1) and §1.1092(d)–1 (determined without regard to section 1092(d)(3)). In addition, Class II assets include certificates of deposit and foreign currency even if they are not actively traded personal property. Examples of Class II assets include U.S. government securities and publicly traded stock.

(iii) Class III assets . Class III assets are accounts receivable, mortgages, and credit card receivables from customers which arise in the ordinary course of business.

(iv) Class IV assets . Class IV assets are stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business.

(v) Class V assets . Class V assets are all assets other than Class I, II, III, IV, VI, and VII assets.

(vi) Class VI assets . Class VI assets are all section 197 intangibles, as defined in section 197, except goodwill and going concern value.

(vii) Class VII assets . Class VII assets are goodwill and going concern value (whether or not the goodwill or going concern value qualifies as a section 197 intangible).

(3) Other items designated by the Inter- nal Revenue Service. Similar items may be added to any class described in this paragraph (b) by designation in the Internal Revenue Bulletin by the Internal Revenue Ser

purchase of T stock on July 1 of Year 2.

(ii) The ADSP formula as applied to these facts is the same as in §1.338–4T(g) Example 1 . Accordingly, the ADSP for T is $87,672.72. The existence of nonrecently purchased T stock is irrelevant for purposes of the ADSP formula, because that formula treats P’s nonrecently purchased T stock in the same manner as T stock not held by P.

(iii) The total tax liability resulting from T’s deemed asset sale, as calculated under the ADSP formula, is $12,672.72.

(iv) If P does not make a gain recognition election, the AGUB of new T’s assets is $85,172.72, determined as follows (In the following formula below, GRP is the grossed-up basis in P’s recently purchased T stock, BNP is P’s basis in nonrecently purchased T stock, L is T’s liabilities, and X is P’s acquisition costs for the recently purchased T stock):

AGUB = GRP + BNP + L + X AGUB = $60,000 ( [(1 - .1)/.8] + $5,000 + $12,672.72 + 0 AGUB = $85,172.72 (v) If P makes a gain recognition election, the AGUB of new T’s assets is $87,672.72, determined as follows:

AGUB = $60,000 ( [(1 - .1)/.8] + $60,000 ( [(1 .1)/.8] ( [.1/(1 - .1)] + $12,672.72 AGUB = $87,672.72 (vi) The calculation of AGUB if P makes a gain recognition election may be simplified as follows:

AGUB = $60,000/.8 + $12,672.72 AGUB = $87,672.72 (vii) As a result of the gain recognition election, P’s basis in its nonrecently purchased T stock is increased from $5,000 to $7,500 (i.e., $60,000 ( [(1 å .1)/.8] ( [.1/(1 å .1)]). Thus, P recognizes a gain in Year 2 with respect to its nonrecently purchased T stock of $2,500 (i.e., $7,500 å $5,000).

Example 2 . On January 1 of Year 1, P purchases one-third of the T stock. On March 1 of Year 1, T distributes a dividend to all of its shareholders. On April 15 of Year 1, P purchases the remaining T stock and makes a section 338 election for T. In appropriate circumstances, the District Director may decrease the AGUB of T to take into account the payment of the dividend and properly reflect the fair market value of T’s assets deemed purchased.

Example 3. (i) T’s sole asset is a building worth $100,000. At this time, T has 100 shares of stock outstanding. On August 1 of Year 1, P purchases 10 of the 100 shares of T stock for $8,000. On June 1 of Year 2, P purchases 50 shares of T stock for $50,000. On June 15 of Year 2, P contributes a tract of land to the capital of T and receives 10 additional shares of T stock as a result of the contribution. Both the basis and fair market value of the land at that time are $10,800. On June 30 of Year 2, P purchases the remaining 40 shares of T stock for $40,000 and makes a section 338 election for T. The AGUB of T is $108,800.

(ii) To prevent the shifting of basis from the contributed property to other assets of T, the District Director may allocate $10,800 of the AGUB to the land, leaving $98,000 to be allocated to the building. See paragraph (f) of this section. Otherwise, applying the allocation rules of §1.338–6T would, on these facts, result in an allocation to the recently contributed land of an amount less than its value of $10,800, with the difference being allocated to the building already held by T.

Par. 7. Sections 1.338–6T and 1.338–7T are added to read as follows: §1.338–6T Allocation of ADSP and AGUB among target assets (temporary).

(a) Scope —(1) In general. This section prescribes rules for allocating ADSP and AGUB among the acquisition date assets of a target for which a section 338 election is made.

(2) Fair market value —(i) In general. Generally, the fair market value of an asset is its gross fair market value (i.e., fair market value determined without regard to mortgages, liens, pledges, or other liabilities). However, for purposes of determining the amount of old target’s deemed sale gain, the fair market value of any property subject to a nonrecourse indebtedness will be treated as being not less than the amount of such indebtedness. (For purposes of the preceding sentence, a liability that was incurred because of the acquisition of the property is disregarded to the extent that such liability was not taken into account in determining old target’s basis in such property.)

(ii) Transaction costs. Transaction costs are not taken into account in allocating ADSP or AGUB to assets in the deemed sale (except indirectly through their effect on the total ADSP or AGUB to be allocated).

(iii) Internal Revenue Service author- ity. In connection with the examination of a return, the Internal Revenue Service may challenge the taxpayer’s determination of the fair market value of any asset by any appropriate method and take into account all factors, including any lack of adverse tax interests between the parties. For example, in certain cases the Internal Revenue Service may make an independent showing of the value of goodwill and going concern value as a means of calling into question the validity of the taxpayer’s valuation of other assets.

(b) General rule for allocating ADSP and AGUB —(1) Reduction in the amount of consideration for Class I assets . Both ADSP and AGUB, in the respective allocation of each, are first reduced by the amount of Class I acquisition date assets. Class I assets are cash and general deposit accounts (including savings and checking accounts) other than certificates of deposit held in banks, savings and loan associations, and other depository institutions. If the amount of Class I assets exceeds AGUB, new target will immedi

January 24, 2000 350 2000–4 I.R.B.

vice (see §601.601(d)(2) of this Chapter).

(c) Certain limitations and other rules for allocation to an asset —(1) Allocation not to exceed fair market value . The amount of ADSP or AGUB allocated to an asset (other than Class VII assets) cannot exceed the fair market value of that asset at the beginning of the day after the acquisition date.

(2) Allocation subject to other rules. The amount of ADSP or AGUB allocated to an asset is subject to other provisions of the Internal Revenue Code or general principles of tax law in the same manner as if such asset were transferred to or acquired from an unrelated person in a sale or exchange. For example, if the deemed asset sale is a transaction described in section 1056(a) (relating to basis limitation for player contracts transferred in connection with the sale of a franchise), the amount of AGUB allocated to a contract for the services of an athlete cannot exceed the limitation imposed by that section. As another example, the amount of AGUB allocated to an amortizable section 197 intangible resulting from an assumption-reinsurance transaction is determined under section 197(f)(5).

(3) Special rule for allocating AGUB when purchasing corporation has nonre- cently purchased stock —(i) Scope . This paragraph (c)(3) applies if at the beginning

of the day after the acquisition date—

(A) The purchasing corporation holds nonrecently purchased stock for which a gain recognition election under section 338(b)(3) and §1.338–5T(d) is not made; and

(B) The hypothetical purchase price determined under paragraph (c)(3)(ii) of this section exceeds the AGUB determined under §1.338–5T(b).

(ii) Determination of hypothetical pur- chase price . Hypothetical purchase price is the AGUB that would result if a gain recognition election were made.

(iii) Allocation of AGUB . Subject to the limitations in paragraphs (c)(1) and (2) of this section, the portion of AGUB (after reduction by the amount of Class I assets) to be allocated to each Class II, III, IV, V, VI, and VII asset of target held at the beginning of the day after the acquisition date is determined by multiplying—

(A) The amount that would be allocated to such asset under the general rules of this section were AGUB equal to the hypothetical purchase price; by

(B) A fraction, the numerator of which is actual AGUB (after reduction by the amount of Class I assets) and the denominator of which is the hypothetical purchase price (after reduction by the amount of Class I assets).

(4) Liabilities taken into account in de- termining amount realized on subsequent disposition . In determining the amount realized on a subsequent sale or other disposition of property deemed purchased by new target, the entire amount of any liability taken into account in AGUB is considered to be an amount taken into account in determining new target’s basis in property that secures the liability for purposes of applying §1.1001–2(a). Thus, if a liability is taken into account in AGUB, §1.1001–2(a)(3) does not prevent the amount of such liability from being treated as discharged within the meaning of §1.1001–2(a)(4) as a result of new target’s sale or disposition of the property which secures such liability.

(d) Examples . The following examples illustrate §§1.338–4T, 1.338–5T, and this section:

Example 1 . (i) T owns 90 percent of the outstanding T1 stock. P purchases 100 percent of the outstanding T stock for $2,000. There are no acquisition costs. P makes a section 338 election for T and, as a result, T1 is considered acquired in a qualified stock purchase. A section 338 election is made for T1. The grossed-up basis of the T stock is $2,000 (i.e., $2,000 ( 1/1).

(ii) The liabilities of T as of the beginning of the day after the acquisition date (including the tax liability for the deemed sale gain) that would, under general principles of tax law, be properly taken into account before the close of new T’s first taxable year, are as follows:

Liabilities (nonrecourse mortgage plus unsecured liabilities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 700

Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000

(iii) The AGUB of T is determined as follows:

Grossed-up basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

AGUB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000 (iv) Assume that ADSP is also $3,000. (v) Assume that, at the beginning of the day after the acquisition date, T’s cash and the fair market values of T’s Class II, III, IV, and V assets are as follows:

Asset Asset Fair Class market

value

I Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200*

II Portfolio of actively traded securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

III Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

IV Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

V Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

V Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

V Investment in T1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,850

*Amount.

2000–4 I.R.B. 351 January 24, 2000

(vi) Under paragraph (b)(1) of this section, the amount of ADSP and AGUB allocable to T’s Class II, III, IV, and V assets is reduced by the amount of cash to $2,800, i.e., $3,000 å $200. $300 of ADSP and of AGUB is then allocated to actively traded securities. $600 of ADSP and of AGUB is then allocated to accounts receivable. $300 of ADSP and of AGUB is then allocated to the inventory. Since the remaining amount of ADSP and of AGUB is $1,600 (i.e., $3,000 å ($200 + $300 + $600 + $300)), an amount which exceeds the sum of the fair market values of T’s Class V assets, the amount of ADSP and of AGUB allocated to each Class V asset is its fair market value:

Building . . . . . . . . . . . . . . . . . . 800 Land . . . . . . . . . . . . . . . . . . . . . 200 Investment in T1 . . . . . . . . . . . . 450 Total . . . . . . . . . . . . . . . . . . . . . $ 1,450 (vii) T has no Class VI assets. The amount of ADSP and of AGUB allocated to T’s Class VII assets (goodwill and going concern value) is $150, i.e., $1,600 - $1,450.

(viii) The grossed-up basis of the T1 stock is $500, i.e., $450 ( 1/.9.

(ix) The liabilities of T as of the beginning of the day after the acquisition date (including the tax liability for the deemed sale gain) that would, under general principles of tax law, be properly taken into account before the close of new T’s first taxable year, are as follows:

General Liabilities . . . . . . . . . . . $ 100 Taxes Payable . . . . . . . . . . . . . . 20 Total . . . . . . . . . . . . . . . . . . . $ 120 (x) The AGUB of T1 is determined as follows: Grossed-up basis of T1 Stock . . $ 500 Liabilities . . . . . . . . . . . . . . . . . 120 AGUB . . . . . . . . . . . . . . . . . . . . $ 620 (xi) Assume that ADSP is also $620. (xii) Assume that at the beginning of the day after the acquisition date, T1’s cash and the fair market

values of its Class IV and VI assets are as follows:

Asset Asset Fair Class Market

Value

I Cash . . . . . . . . . . . . . . $ 50*

IV Inventory . . . . . . . . . . 200

VI Patent . . . . . . . . . . . . . 350

Total . . . . . . . . . . . . $ 600

• Amount. (xiii) The amount of ADSP and of AGUB allocable to T1’s Class IV and VI assets is first reduced by the $50 of cash.

(xiv) Because the remaining amount of ADSP and of AGUB ($570) is an amount which exceeds the fair market value of T1’s only Class IV asset, the inventory, the amount allocated to the inventory is its fair market value ($200). After that, the remaining amount of ADSP and of AGUB ($370) exceeds the fair market value of T1’s only Class VI asset, the patent. Thus, the amount of ADSP and of AGUB allocated to the patent is its fair market value ($350).

(xv) The amount of ADSP and of AGUB allocated to T1’s Class VII assets (goodwill and going concern value) is $20, i.e., $570 å $550.

Example 2 . (i) Assume that the facts are the same as in Example 1 except that P has, for five years, owned 20 percent of T’s stock, which has a basis in P’s hands at the beginning of the day after the acquisition date of $100, and P purchases the remaining 80 percent of T’s stock for $1,600. P does not make a gain recognition election under section 338(b)(3).

(ii) Under §1.338–5T(c), the grossed-up basis of recently purchased T stock is $1,600, i.e., $1,600 ( (1 - .2)/.8.

(iii) The AGUB of T is determined as follows:

Grossed-up basis of recently purchased stock as determined under §1.338–5T(c) ($1,600 x

(1 - .2)/.8) . . . . . . . . . . . . . . . . . . . . . $ 1,600

Basis of nonrecently purchased stock . . . . . . . . . . . . . . . . . . . . . . . . . 100

Liabilities . . . . . . . . . . . . . . . . . . . . . 1,000

AGUB . . . . . . . . . . . . . . . . . . . . . $ 2,700 (iv) Since P holds nonrecently purchased stock, the hypothetical purchase price of the T stock must be computed and is determined as follows:

Grossed-up basis of recently purchased stock as determined under §1.338–5T(c) ($1,600 ( (1 - .2)/.8) . . . . . . . . . . . . $ 1,600

Basis of nonrecently purchased stock as if the gain recognition election under §1.338–5T(d)(2) had been made ($1,600 ( .2/(1 å .2)) . . . . . . . . . . . . . . . . . . . 400

Liabilities . . . . . . . . . . . . . . . . . . . . . 1,000

Total . . . . . . . . . . . . . . . . . . . . . . $ 3,000 (v) Since the hypothetical purchase price ($3,000) exceeds the AGUB ($2,700) and no gain recognition election is made under section 338(b)(3), AGUB is allocated under paragraph (c)(3) of this section.

(vi) First, an AGUB amount equal to the hypothetical purchase price ($3,000) is allocated among the assets under the general rules of this section. The allocation is set forth in the column below entitled Original Allocation. Next, the allocation to each asset in Class II through Class VII is multiplied by a fraction having a numerator equal to the actual AGUB reduced by the amount of Class I assets ($2,700 å $200 = $2,500) and a denominator equal to the hypothetical purchase price reduced by the amount of Class I assets ($3,000 å $200 = $2,800), or 2,500/2,800. This produces the Final Allocation:

Class Asset Original Final Allocation Allocation I Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200 $ 200 II Portfolio of actively traded securities . . . . . . . . . . . . . . . . . . . . . . 300 268* III Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 536 IV Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 268 V Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 714 V Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 178 V Investment in T1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 402 VII Goodwill and going concern value . . . . . . . . . . . . . . . . . . . . . . . . 150 134 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000 $ 2,700

• All numbers rounded for convenience.

under §1.338–6T to a given asset is different from the original allocation to it, the difference is added to or subtracted from the original allocation to the asset, as appropriate. Amounts allocable to an acquisition date asset (or with respect to a disposed-of acquisition date asset) are subject to all the asset allocation rules (for example, the fair market value limitation in §1.338–6T(c)(1)) as if the redetermined ADSP or AGUB were the ADSP or AGUB on the acquisition date.

(c) Special rules for ADSP —(1) In-

§1.338–7T Allocation of redetermined ADSP and AGUB among target assets (temporary).

(a) Scope. ADSP and AGUB are redetermined at such time and in such amount as an increase or decrease would be required under general principles of tax law for the elements of ADSP or AGUB. This section provides rules for allocating redetermined ADSP or AGUB when increases or decreases with respect to the elements of ADSP or AGUB are required after the close of new target’s first taxable year.

For determining and allocating ADSP or AGUB when increases or decreases are required with respect to the elements of ADSP or AGUB before the close of new target’s first taxable year, see §§1.338–4T, 1.338–5T, and 1.338–6T. (b) Allocation of redetermined ADSP and AGUB . When ADSP or AGUB is redetermined, a new allocation of ADSP or AGUB is made by allocating the redetermined ADSP or AGUB amount under the rules of §1.338–6T. If the allocation of the redetermined ADSP or AGUB amount

January 24, 2000 352 2000–4 I.R.B.

has been disposed of, depreciated, amortized, or depleted. A similar rule applies when an amount is subtracted from the original allocation to the asset. For purposes of the preceding sentence, an asset is considered to have been disposed of to the extent that its allocable portion of the decrease in AGUB would reduce its basis below zero.

(2) Section 38 property . Section 1.47–2(c) applies to a reduction in basis of section 38 property under this section.

(e) Examples . The following examples illustrate this section. Any amount described in the following examples is exclusive of interest. For rules characterizing deferred contingent payments as principal or interest, see §§1.483–4, 1.1274–2(g), and 1.1275–4(c). The examples are as follows:

Example 1 . (i)(A) T’s assets other than goodwill and going concern value, and their fair market values at the beginning of the day after the acquisition date, are as follows: Asset Asset Fair Class Market

Value

V Building . . . . . . . . . . . . . $ 100

V Stock of X (not a target) . 200

Total . . . . . . . . . . . . . . $ 300 (B) T has no liabilities other than a contingent liability that would not be taken into account under general principles of tax law in an asset sale between unrelated parties when the buyer assumed the liability or took property subject to it.

(ii)(A) On September 1, 2000, P purchases all of the outstanding stock of T for $270 and makes a section 338 election for T. The grossed-up basis of the T stock and T’s AGUB are both $270. The AGUB is ratably allocated among T’s Class V assets in proportion to their fair market values as follows: Asset Basis

Building ($270 ( 100/300) . . . . . . . . $ 90

Stock ($270 ( 200/300) . . . . . . . . . . . 180

Total . . . . . . . . . . . . . . . . . . . . . . . $270 (B) No amount is allocated to the Class VII assets. New T is a calendar year taxpayer. Assume that the X stock is a capital asset in the hands of new T.

(iii) On January 1, 2001, new T sells the X stock and uses the proceeds to purchase inventory.

(iv) Pursuant to events on June 30, 2002, the contingent liability of old T is at that time properly taken into account under general principles of tax law. The amount of the liability is $60.

(v) T’s AGUB increases by $60 from $270 to $330. This $60 increase in AGUB is first allocated among T’s acquisition date assets in accordance with the provisions of §1.338–6T. Because the redetermined AGUB for T ($330) exceeds the sum of the fair market values at the beginning of the day after the acquisition date of the Class V acquisition date assets ($300), AGUB allocated to those assets is limited to those fair market values under §1.338

creases or decreases in deemed sale gain taxable notwithstanding old target ceases to exist. To the extent general principles of tax law would require a seller in an actual asset sale to account for events relating to the sale that occur after the sale date, target must make such an accounting. Target is not precluded from realizing additional deemed sale gain because the target is treated as a new corporation after the acquisition date.

(2) Procedure for transactions in which section 338(h)(10) is not elected - (i) Deemed sale gain included in new target’s return. If an election under section 338(h)(10) is not made, any additional deemed sale gain of old target resulting from an increase or decrease in the ADSP is included in new target’s income tax return for new target’s taxable year in which the increase or decrease is taken into account. For example, if after the acquisition date there is an increase in the allocable ADSP of section 1245 property for which the recomputed basis (but not the adjusted basis) exceeds the portion of the ADSP allocable to that particular asset on the acquisition date, the additional gain is treated as ordinary income to the extent it does not exceed such excess amount. See paragraph (c)(2)(ii) of this section for the special treatment of old target’s carryovers and carrybacks. Although included in new target’s income tax return, the deemed sale gain is separately accounted for as an item of old target and may not be offset by income, gain, deduction, loss, credit, or other amount of new target. The amount of tax on income of old target resulting from an increase or decrease in the ADSP is determined as if such deemed sale gain had been recognized in old target’s taxable year ending at the close of the acquisition date.

(ii) Carryovers and carrybacks —(A) Loss carryovers to new target taxable years. A net operating loss or net capital loss of old target may be carried forward to a taxable year of new target, under the principles of section 172 or 1212, as applicable, but is allowed as a deduction only to the extent of any recognized income of old target for such taxable year, as described in paragraph (c)(2)(i) of this section. For this purpose, however, taxable years of new target are not taken into account in applying the limitations in section 172(b)(1) or 1212(a)(1)(B) (or other

similar limitations). In applying sections 172(b) and 1212(a)(1), only income, gain, loss, deduction, credit, and other amounts of old target are taken into account. Thus, if old target has an unexpired net operating loss at the close of its taxable year in which the deemed asset sale occurred that could be carried forward to a subsequent taxable year, such loss may be carried forward until it is absorbed by old target’s income.

(B) Loss carrybacks to taxable years of old target . An ordinary loss or capital loss accounted for as a separate item of old target under paragraph (c)(2)(i) of this section may be carried back to a taxable year of old target under the principles of section 172 or 1212, as applicable. For this purpose, taxable years of new target are not taken into account in applying the limitations in section 172(b) or 1212(a) (or other similar limitations).

(C) Credit carryovers and carrybacks. The principles described in paragraphs (c)(2)(ii)(A) and (B) of this section apply to carryovers and carrybacks of amounts for purposes of determining the amount of a credit allowable under part IV, subchapter A, chapter 1 of the Internal Revenue Code. Thus, for example, credit carryovers of old target may offset only income tax attributable to items described in paragraph (c)(2)(i) of this section.

(3) Procedure for transactions in which section 338(h)(10) is elected . If an election under section 338(h)(10) is made, any additional deemed sale gain resulting from an increase or decrease in the ADSP is accounted for in determining the taxable income (or other amount) of the member of the selling consolidated group, the selling affiliate, or the S corporation shareholders to which such income, loss, or other amount is attributable for the taxable year in which such increase or decrease is taken into account.

(d) Special rules for AGUB —(1) Effect of disposition or depreciation of acquisi- tion date assets. If an acquisition date asset has been disposed of, depreciated, amortized, or depleted by new target before an amount is added to the original allocation to the asset, the increased amount otherwise allocable to such asset is taken into account under general principles of tax law that apply when part of the cost of an asset not previously taken into account in basis is paid or incurred after the asset

2000–4 I.R.B. 353 January 24, 2000

6T(c)(1). As there are no Class VI assets, the remaining AGUB of $30 is allocated to goodwill and going concern value (Class VII assets). The amount of increase in AGUB allocated to each acquisition date asset is determined as follows: Asset Original Redetermined Increase AGUB AGUB

Building . . . . $ 90 $ 100 $ 10

X Stock . . . . . 180 200 20

Goodwill and going concern value . . . . . . . 0 30 30

Total . . . . . . $ 270 $ 330 $ 60 (vi) Since the X stock was disposed of before the contingent liability was properly taken into account for tax purposes, no amount of the increase in AGUB attributable to such stock may be allocated to any T asset. Rather, such amount ($20) is allowed as a capital loss to T for the taxable year 2002 under the principles of Arrowsmith v. Commissioner, 344 U.S. 6 (1952). In addition, the $10 increase in AGUB allocated to the building and the $30 increase in AGUB allocated to the goodwill and going concern value are treated as basis redeterminations in 2002. See paragraph (d)(1) of this section.

Example 2 . (i) On January 1, 2002, P purchases all of the outstanding stock of T and makes a section 338 election for T. Assume that ADSP and AGUB of T are both $500 and are allocated among T’s acquisition date assets as follows: Asset Asset Basis Class

V Machinery . . . . . . . . . . . . . . $ 150

V Land . . . . . . . . . . . . . . . . . . 250

VII Goodwill and going. . . . . . . concern value . . . . . . . . . . . 100

Total . . . . . . . . . . . . . . . $ 500 (ii) On September 30, 2004, P filed a claim against the selling shareholders of T in a court of appropriate jurisdiction alleging fraud in the sale of the T stock.

(iii) On January 1, 2007, the former shareholders refund $140 of the purchase price to P in a settlement of the lawsuit. Assume that, under general principles of tax law, both the seller and the buyer properly take into account such refund when paid. Assume also that the refund has no effect on the tax liability for the deemed sale gain. This refund results in a decrease of T’s ADSP and AGUB of $140, from $500 to $360.

(iv) The redetermined ADSP and AGUB of $360 is allocated among T’s acquisition date assets. Be

cause ADSP and AGUB do not exceed the fair market value of the Class V assets, the ADSP and AGUB amounts are allocated to the Class V assets in proportion to their fair market values at the beginning of the day after the acquisition date. Thus, $135 ($150 ( ($360/($150 + $250))) is allocated to the machinery and $225 ($250 ( ($360/($150 + $250))) is allocated to the land. Accordingly, the basis of the machinery is reduced by $15 ($150 original allocation å $135 redetermined allocation) and the basis of the land is reduced by $25 ($250 original allocation å $225 redetermined allocation). No amount is allocated to the Class VII assets. Accordingly, the basis of the goodwill and going concern value is reduced by $100 ($100 original allocation å $0 redetermined allocation).

(v) Assume that, as a result of deductions under section 168, the adjusted basis of the machinery immediately before the decrease in AGUB is zero. The machinery is treated as if it were disposed of before the decrease is taken into account. In 2007, T recognizes income of $15, the character of which is determined under the principles of Arrowsmith v. Com- missioner, 344 U.S. 6 (1952), and the tax benefit rule. No adjustment to the basis of T’s assets is made for any tax paid on this amount. Assume also that, as a result of amortization deductions, the adjusted basis of the goodwill and going concern value immediately before the decrease in AGUB is $40. A similar adjustment to income is made in 2007 with respect to the $60 of previously amortized goodwill and going concern value.

(vi) In summary, the basis of T’s acquisition date assets, as of January 1, 2007, is as follows: Asset Basis

Machinery . . . . . . . . . . . . . . . . . . . . $ 0

Land . . . . . . . . . . . . . . . . . . . . . . . . . 225

Goodwill and going concern value . . . . . . . . . . . . . . . . . . 0 Example 3 . (i) Assume that the facts are the same as §1.338–6T(d) Example 2 except that the recently purchased stock is acquired for $1,600 plus additional payments that are contingent upon T’s future earnings. Assume that, under general principles of tax law, such later payments are properly taken into account when paid. Thus, T’s AGUB, determined as of the beginning of the day after the acquisition date (after reduction by T’s cash of $200), is $2,500 and is allocated among T’s acquisition date assets under §1.338–6T(c)(3)(iii) as follows: Class Asset Final Allocation

I Cash . . . . . . . . . . . . . . . $ 200

II Portfolio of actively

traded securities . . . . . . 268*

III Accounts receivable . . 536

IV Inventory . . . . . . . . . . . 268

V Building . . . . . . . . . . . . 714

V Land . . . . . . . . . . . . . . . 178

V Investment in T1 . . . . . 402

VII Goodwill and going concern value . . . . . . . . 134

Total . . . . . . . . . . . . . $ 2,700

• All numbers rounded for convenience. (ii) After the close of new target’s first taxable year, P pays an additional $200 for its recently purchased T stock. Assume that the additional consideration paid would not increase T’s tax liability for the deemed sale gain.

(iii) T’s AGUB increases by $200, from $2,700 to $2,900. This $200 increase in AGUB is accounted for in accordance with the provisions of §1.338–6T(c)(3)(iii).

(iv) The hypothetical purchase price of the T stock is redetermined as follows:

Grossed-up basis of recently purchased stock as determined under §1.338–5T(c) ($1,800 ( (1 - .2)/.8) . . . . . . . . . . . . . . . . . . $ 1,800 Basis of nonrecently purchased stock as if the gain recognition election under §1.338–5T(d)(2) had been made ($1,800 ( .2/(1 å .2)) . . . . . . . . . . . . . . . . . . 450 Liabilities . . . . . . . . . . . . . . . . . . . . 1,000 Total . . . . . . . . . . . . . . . . . . . . . . . . $ 3,250 (v) Since the redetermined hypothetical purchase price ($3,250) exceeds the redetermined AGUB ($2,900) and no gain recognition election was made under section 338(b)(3), the rules of §1.338–6T(c)(3)(iii) are reapplied using the redetermined hypothetical purchase price and the redetermined AGUB.

(vi) First, an AGUB amount equal to the redetermined hypothetical purchase price ($3,250) is allocated among the assets under the general rules of §1.338–6T. The allocation is set forth in the column below entitled Hypothetical Allocation . Next, the allocation to each asset in Class II through Class VII is multiplied by a fraction with a numerator equal to the actual redetermined AGUB reduced by the amount of Class I assets ($2,900 å $200 = $2,700) and a denominator equal to the redetermined hypothetical purchase price reduced by the amount of Class I assets ($3,250 å $200 = $3,050), or 2,700/3,050. This produces the Final Allocation :

Class Asset Hypothetical Final Allocation Allocation I Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200 $ 200 II Portfolio of actively traded securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 266* III Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 531 IV Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 266 V Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 708 V Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 177 V Investment in T1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 398 VII Goodwill and going concern value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 354 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,250 $ 2900

• All numbers rounded for convenience.

January 24, 2000 354 2000–4 I.R.B.

(vii) As illustrated by this example, reapplying §1.338–6T(c)(3) results in a basis increase for

some assets and a basis decrease for other assets. The amount of redetermined AGUB allocated to

each acquisition date asset is determined as follows:

Asset Original Redetermined Increase (c)(3) (c)(3) (decrease) allocation allocation Portfolio of actively traded securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 268 $ 266 $ (2) Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 536 531 (5) Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 266 (2) Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 714 708 (6) Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 177 (1) Investment in T1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402 398 (4) Goodwill and going concern value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 354 220 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,500 $ 2,700 $ 200

Example 4 . (i) On January 1, 2001, P purchases all of the outstanding T stock and makes a section 338 election for T. P pays $700 of cash and promises also to pay a maximum $300 of contingent consideration at various times in the future. Assume that, under general principles of tax law, such later payments are properly taken into account by P when paid. Assume also, however, that the current fair market value of the contingent payments is reasonably ascertainable. The fair market value of T’s assets (other than goodwill and going concern value) as of the beginning of the following day is as follows: Asset Assets Fair Class market

value

V Equipment . . . . . . . . . . . . . $ 200

V Non-actively traded securities . . . . . . . . . . . . . . 100

V Building. . . . . . . . . . . . . . . 500

Total . . . . . . . . . . . . . . . 800 (ii) T has no liabilities. The AGUB is $700. In calculating ADSP, assume that, under §1.1001–1, the current amount realized attributable to the contingent consideration is $200. ADSP is therefore $900 ($700 cash plus $200).

(iii) (A) The AGUB of $700 is ratably allocated among T’s Class V acquisition date assets in proportion to their fair market values as follows: Asset Basis

Equipment ($700 ( 200/800) . . . . . . . $175.00

Non-actively traded securities ($700 ( 100/800) . . . . . . . . . . . . . . . . . 87.50

Building ($700 ( 500/800) . . . . . . . . . 437.50

Total . . . . . . . . . . . . . . . . . . . . . . . . $700.00 (B) No amount is allocated to goodwill or going concern value.

(iv) (A) The ADSP of $900 is ratably allocated

among T’s Class V acquisition date assets in proportion to their fair market values as follows: Asset Basis

Equipment . . . . . . . . . . . . . . . . . . . . . $200

Non-actively traded securities . . . . . . 100

Building . . . . . . . . . . . . . . . . . . . . . . . 500

Total . . . . . . . . . . . . . . . . . . . . . . . . . . $800 (B) The remaining ADSP, $100, is allocated to goodwill and going concern value (Class VII).

(v) P and T file a consolidated return for 2001 and each following year with P as the common parent of the affiliated group.

(vi) In 2004, a contingent amount of $120 is paid by P. Assume that, under general principles of tax law, the payment is properly taken into account by P at the time made. In 2004, there is an increase in T’s AGUB of $120. The amount of the increase allocated to each acquisition date asset is determined as follow s:

Asset Original Redetermined Increase AGUB AGUB Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 175.00 $ 200.00 $ 25.00 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87.50 100.00 12.50 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437.50 500.00 62.50 Goodwill and going concern value . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.00 20.00 20.00 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 700.00 $ 820.00 $ 120.00

Par. 8. Section 1.338–10T is added to read as follows: §1.338–10T Filing of returns (temporary).

(a) Returns including tax liability from deemed asset sale —(1) In general. Except as provided in paragraphs (a)(2) and (3) of this section, any deemed sale gain is reported on the final return of old target filed for old target’s taxable year that ends at the close of the acquisition date. If old target is the common parent of an affiliated group, the final return may be a consolidated return (any such consolidated return must also include any deemed sale gain of any members of the consolidated group that are acquired by the purchasing corporation on the same acquisition date as old target).

(2) Old target’s final taxable year oth- erwise included in consolidated return of

selling group —(i) General rule . If the selling group files a consolidated return for the period that includes the acquisition date, old target is disaffiliated from that group immediately before the deemed asset sale and must file a deemed sale return separate from the group that includes only the deemed sale gain and the carryover items specified in paragraph (a)(2)(iii) of this section. The deemed asset sale occurs at the close of the acquisition date and is the last transaction of old target. Any transactions of old target occurring on the acquisition date other than the deemed asset sale are included in the selling group’s consolidated return. A deemed sale return includes a combined deemed sale return as defined in paragraph (a)(4) of this section.

(ii) Separate taxable year . The deemed asset sale included in the deemed sale re

turn under this paragraph (a)(2) occurs in a separate taxable year, except that old target’s taxable year of the sale and the consolidated year of the selling group that includes the acquisition date are treated as the same year for purposes of determining the number of years in a carryover or carryback period.

(iii) Carryover and carryback of tax at- tributes . Target’s attributes may be carried over to, and carried back from, the deemed sale return under the rules applicable to a corporation that ceases to be a member of a consolidated group.

(iv) Old target is a component member of purchasing corporation’s controlled group. For purposes of its deemed sale return, target is a component member of the controlled group of corporations including the purchasing corporation unless target is treated as an excluded member

2000–4 I.R.B. 355 January 24, 2000

under section 1563(b)(2).

(3) Old target is an S corporation . If target is an S corporation for the period that ends on the day before the acquisition date, old target must file a deemed sale return as a C corporation. For this purpose, the principles of paragraph (a)(2) of this section apply. This paragraph (a)(3) does not apply if an election under section 338(h)(10) is made for the S corporation. (4) Combined deemed sale return —(i) General rule . Under section 338(h)(15), a combined deemed sale return (combined return) may be filed for all targets from a single selling consolidated group (as defined in §1.338(h)(10)–1T(b)(3)) that are acquired by the purchasing corporation on the same acquisition date and that otherwise would be required to file separate deemed sale returns. The combined return must include all such targets. For example, T and T1 may be included in a combined return if—

(A) T and T1 are directly owned subsidiaries of S;

(B) S is the common parent of a consolidated group; and

(C) P makes qualified stock purchases of T and T1 on the same acquisition date.

(ii) Gain and loss offsets. Gains and losses recognized on the deemed asset sales by targets included in a combined return are treated as the gains and losses of a single target. In addition, loss carryovers of a target that were not subject to the separate return limitation year restrictions (SRLY restrictions) of the consolidated return regulations while that target was a member of the selling consolidated group may be applied without limitation to the gains of other targets included in the combined return. If, however, a target has loss carryovers that were subject to the SRLY restrictions while that target was a member of the selling consolidated group, the use of those losses in the combined return continues to be subject to those restrictions, applied in the same manner as if the combined return were a consolidated return. A similar rule applies, when appropriate, to other tax attributes.

(iii) Procedure for filing a combined re- turn . A combined return is made by filing a single corporation income tax return in lieu of separate deemed sale returns for all targets required to be included in the combined return. The combined return re

flects the deemed asset sales of all targets required to be included in the combined return. If the targets included in the combined return constitute a single affiliated group within the meaning of section 1504(a), the income tax return is signed by an officer of the common parent of that group. Otherwise, the return must be signed by an officer of each target included in the combined return. Rules similar to the rules in §1.1502–75(j) apply for purposes of preparing the combined return. The combined return must include an attachment prominently identified as an “ELECTION TO FILE A COMBINED RETURN UNDER SECTION 338(h)(15).” The attachment must— (A) Contain the name, address, and employer identification number of each target required to be included in the combined return;

(B) Contain the following declaration (or a substantially similar declaration): EACH TARGET IDENTIFIED IN THIS ELECTION TO FILE A COMBINED RETURN CONSENTS TO THE FILING OF A COMBINED RETURN;

(C) For each target, be signed by a person who states under penalties of perjury that he or she is authorized to act on behalf of such target.

(iv) Consequences of filing a combined return . Each target included in a combined return is severally liable for any tax associated with the combined return. See §1.338–1T(b)(3).

(5) Deemed sale excluded from pur- chasing corporation’s consolidated re- turn . Old target may not be considered a member of any affiliated group that includes the purchasing corporation with respect to its deemed asset sale.

(6) Due date for old target’s final re- turn —(i) General rule. Old target’s final return is generally due on the 15th day of the third calendar month following the month in which the acquisition date occurs. See section 6072 (time for filing income tax returns).

(ii) Application of §1.1502–76(c) —(A) In general . Section 1.1502–76(c) applies to old target’s final return if old target was a member of a selling group that did not file consolidated returns for the taxable year of the common parent that precedes the year that includes old target’s acquisition date. If the selling group has not filed a consolidated return that includes

old target’s taxable period that ends on the acquisition date, target may, on or before the final return due date (including extensions), either—

( 1 ) File a deemed sale return on the assumption that the selling group will file the consolidated return; or

( 2 ) File a return for so much of old target’s taxable period as ends at the close of the acquisition date on the assumption that the consolidated return will not be filed.

(B) Deemed extension . For purposes of applying §1.1502–76(c)(2), an extension of time to file old target’s final return is considered to be in effect until the last date for making the election under section 338. (C) Erroneous filing of deemed sale re- turn . If, under this paragraph (a)(6)(ii), target files a deemed sale return but the selling group does not file a consolidated return, target must file a substituted return for old target not later than the due date (including extensions) for the return of the common parent with which old target would have been included in the consolidated return. The substituted return is for so much of old target’s taxable year as ends at the close of the acquisition date. Under §1.1502–76(c)(2), the deemed sale return is not considered a return for purposes of section 6011 (relating to the general requirement of filing a return) if a substituted return must be filed.

(D) Erroneous filing of return for regu- lar tax year . If, under this paragraph (a)(6)(ii), target files a return for so much of old target’s regular taxable year as ends at the close of the acquisition date but the selling group files a consolidated return, target must file an amended return for old target not later than the due date (including extensions) for the selling group’s consolidated return. (The amended return is a deemed sale return.)

(E) Last date for payment of tax. If either a substituted or amended final return of old target is filed under this paragraph (a)(6)(ii), the last date prescribed for payment of tax is the final return due date (as defined in paragraph (a)(6)(i) of this section).

(7) Examples. The following examples illustrate this paragraph (a):

Example 1 . (i) S is the common parent of a consolidated group that includes T. The S group files calendar year consolidated returns. At the close of June 30 of Year 1, P makes a qualified stock purchase of T from S. P makes a section 338 election for T, and T’s deemed asset sale occurs as of the

January 24, 2000 356 2000–4 I.R.B.

338(h)(10) election. This section also prescribes the consequences of such election. The rules of this section are in addition to the rules of §§1.338–0T through and 1.338(i)–1T and, in appropriate cases, apply instead of the rules of §§1.338–0T through 1.338–7T, 1.338–8, 1.338–9, 1.338–10T, and 1.338(i)–1T. (b) Definitions —(1) Consolidated tar- get . A consolidated target is a target that is a member of a consolidated group within the meaning of §1.1502–1(h) on the acquisition date and is not the common parent of the group on that date.

(2) Selling consolidated group. A sell- ing consolidated group is the consolidated group of which the consolidated target is a member on the acquisition date.

(3) Selling affiliate; affiliated target . A selling affiliate is a domestic corporation that owns on the acquisition date an amount of stock in a domestic target, which amount of stock is described in section 1504(a)(2), and does not join in filing a consolidated return with the target. In such case, the target is an affili- ated target .

(4) S corporation target . An S corpo- ration target is a target that is an S corporation immediately before the acquisition date.

(5) S corporation shareholders. S cor- poration shareholders are the S corporation target’s shareholders. Unless otherwise indicated, a reference to S corporation shareholders refers both to S corporation shareholders who do and those who do not sell their target stock.

(6) Liquidation . Any reference in this section to a liquidation is treated as a reference to the transfer described in paragraph (d)(4) of this section notwithstanding its ultimate characterization for Federal income tax purposes.

(c) Section 338(h)(10) election —(1) In genera l. A section 338(h)(10) election may be made for T if P acquires stock meeting the requirements of section 1504(a)(2) from a selling consolidated group, a selling affiliate, or the S corporation shareholders in a qualified stock purchase.

(2) Simultaneous joint election require- ment . A section 338(h)(10) election is made jointly by P and the selling consolidated group (or the selling affiliate or the S corporation shareholders) on Form

close of T’s acquisition date (June 30).

(ii) T is considered disaffiliated for purposes of reporting the deemed sale gain. Accordingly, T is included in the S group’s consolidated return through T’s acquisition date except that the tax liability for the deemed sale gain is reported in a separate deemed sale return of T. Provided that T is not treated as an excluded member under section 1563(b)(2), T is a component member of P’s controlled group for the taxable year of the deemed asset sale, and the taxable income bracket amounts available in calculating tax on the deemed sale return must be limited accordingly.

(iii) If P purchased the stock of T at 10 a.m. on June 30 of Year 1, the results would be the same. See paragraph (a)(2)(i) of this section.

Example 2. The facts are the same as in Example 1, except that the S group does not file consolidated returns. T must file a separate return for its taxable year ending on June 30 of Year 1, which return includes the deemed asset sale.

(b) Waiver —(1) Certain additions to tax. An addition to tax or additional amount (addition) under subchapter A of chapter 68 of the Internal Revenue Code arising on or before the last day for making the election under section 338 because of circumstances that would not exist but for an election under section 338, is waived if—

(i) Under the particular statute the addition is excusable upon a showing of reasonable cause; and

(ii) Corrective action is taken on or before the last day.

(2) Notification . The Internal Revenue Service should be notified at the time of correction (e.g., by attaching a statement to a return that constitutes corrective action) that the waiver rule of this paragraph (b) is being asserted.

(3) Elections or other actions required to be specified on a timely filed return (i) In general . If paragraph (b)(1) of this section applies or would apply if there were an underpayment, any election or other action that must be specified on a timely filed return for the taxable period covered by the late filed return described in paragraph (b)(1) of this section is considered timely if specified on a late-filed return filed on or before the last day for making the election under section 338.

(ii) New target in purchasing corpora- tion’s consolidated return . If new target is includible for its first taxable year in a consolidated return filed by the affiliated group of which the purchasing corporation is a member on or before the last day for making the election under section 338, any election or other action that must be specified in a timely filed return for new

target’s first taxable year (but which is not specified in the consolidated return) is considered timely if specified in an amended return filed on or before such last day, at the place where the consolidated return was filed.

(4) Examples . The following examples illustrate this paragraph (b):

Example 1 . T is an unaffiliated corporation with a tax year ending March 31. At the close of September 20 of Year 1, P makes a qualified stock purchase of T. P does not join in filing a consolidated return. P makes a section 338 election for T on or before June 15 of Year 2, which causes T’s taxable year to end as of the close of September 20 of Year 1. An income tax return for T’s taxable period ending on September 20 of Year 1 was due on December 15 of Year 1. Additions to tax for failure to file a return and to pay tax shown on a return will not be imposed if T’s return is filed and the tax paid on or before June 15 of Year 2. (This waiver applies even if the acquisition date coincides with the last day of T’s former taxable year, i.e., March 31 of Year 2.) Interest on any underpayment of tax for old T’s short taxable year ending September 20 of Year 1 runs from December 15 of Year 1. A statement indicating that the waiver rule of this paragraph is being asserted should be attached to T’s return.

Example 2. Assume the same facts as in Example 1 . Assume further that new T adopts the calendar year by filing, on or before June 15 of Year 2, its first return (for the period beginning on September 21 of Year 1 and ending on December 31 of Year 1) indicating that a calendar year is chosen. See §1.3381T(b)(1). Any additions to tax or amounts described in this paragraph (b) that arise because of the late filing of a return for the period ending on December 31 of Year 1 are waived, because they are based on circumstances that would not exist but for the section 338 election. Notwithstanding this waiver, however, the return is still considered due March 15 of Year 2, and interest on any underpayment runs from that date.

Example 3 . Assume the same facts as in Example 2, except that T’s former taxable year ends on October 31. Although prior to the election old T had a return due on January 15 of Year 2 for its year ending October 31 of Year 1, that return need not be filed because a timely election under section 338 was made. Instead, old T must file a final return for the period ending on September 20 of Year 1, which is due on December 15 of Year 1.

§§1.338(b)–1, 1.338(b)–2T, 1.338(b)–3T, and 1.338(h)(10)–1

[Removed]

Par. 9. Sections 1.338(b)–1, 1.338(b)–2T, and 1.338(b)–3T, and 1.338(h)(10)–1 are removed. Par. 10. Section 1.338(h)(10)–1T is added to read as follows: §1.338(h)(10)–1T Deemed asset sale and liquidation (temporary).

(a) Scope . This section prescribes rules for qualification for a section 338(h)(10) election and for making a section

2000–4 I.R.B. 357 January 24, 2000

8023 in accordance with the instructions to the form. S corporation shareholders who do not sell their stock must also consent to the election. The section 338(h)(10) election must be made not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs.

(3) Irrevocability . A section 338(h)(10) election is irrevocable. If a section 338(h)(10) election is made for T, a section 338 election is deemed made for T.

(4) Effect of invalid election . If a section 338(h)(10) election for T is not valid, the section 338 election for T is also not valid.

(d) Certain consequences of section 338(h)(10) election . For purposes of subtitle A of the Internal Revenue Code (except as provided in §1.338–1T(b)(2)), the consequences to the parties of making a section 338(h)(10) election for T are as follows:

(1) P . P is automatically deemed to have made a gain recognition election for its nonrecently purchased T stock, if any. The effect of a gain recognition election includes a taxable deemed sale by P on the acquisition date of any nonrecently purchased target stock. See §1.338–5T(d).

(2) New T . The AGUB for new T’s assets is determined under §1.338–5T and is allocated among the acquisition date assets under §§1.338–6T and 1.338–7T. Notwithstanding paragraph (d)(4) of this section (deemed liquidation of old T), new T remains liable for the tax liabilities of old T (including the tax liability for the deemed sale gain). For example, new T remains liable for the tax liabilities of the members of any consolidated group that are attributable to taxable years in which those corporations and old T joined in the same consolidated return. See §1.1502–6(a).

(3) Old T—deemed sale—(i) In gen- eral. Old T is treated as transferring all of its assets to an unrelated person in exchange for consideration that includes the assumption of or taking subject to liabilities in a single transaction at the close of the acquisition date (but before the deemed liquidation). See §1.338–1T(a) regarding the tax characterization of the deemed asset sale. ADSP for old T is determined under §1.338–4T and allocated among the acquisition date assets under

§§1.338–6T and 1.338–7T. Old T realizes the deemed sale gain from the deemed asset sale before the close of the acquisition date while old T is a member of the selling consolidated group (or owned by the selling affiliate or owned by the S corporation shareholders). If T is an affiliated target, or an S corporation target, the principles of §§1.338–2T(c)(10) and 1.338–10T(a)(1), (5), and (6)(i) apply to the return on which the deemed sale gain is reported. When T is an S corporation target, T’s S election continues in effect through the close of the acquisition date (including the time of the deemed asset sale and the deemed liquidation) notwithstanding section 1362(d)(2)(B). Also, when T is an S corporation target, any direct and indirect subsidiaries of T which T has elected to treat as qualified subchapter S subsidiaries under section 1361(b)(3) remain qualified subchapter S subsidiaries through the close of the acquisition date. No similar rule applies when a qualified subchapter S subsidiary, as opposed to the S corporation that is its owner, is the target the stock of which is actually purchased.

(ii) Tiered targets . In the case of parent-subsidiary chains of corporations making elections under section 338(h)(10), the deemed asset sale of a parent corporation is considered to precede that of its subsidiary. See §1.338–3T(4)(i).

(4) Old T and selling consolidated group, selling affiliate, or S corporation shareholders—deemed liquidation; tax characterization —(i) In general . Old T is treated as if, before the close of the acquisition date, after the deemed asset sale in paragraph (d)(3) of this section, and while old T is a member of the selling consolidated group (or owned by the selling affiliate or owned by the S corporation shareholders), it transferred all of its assets to members of the selling consolidated group, the selling affiliate, or S corporation shareholders and ceased to exist. The transfer from old T is characterized for Federal income tax purposes in the same manner as if the parties had actually engaged in the transactions deemed to occur because of this section and taking into account other transactions that actually occurred or are deemed to occur. For example, the transfer may be treated as a distribution in pursuance of a plan of reor

ganization, a distribution in complete cancellation or redemption of all its stock, one of a series of distributions in complete cancellation or redemption of all its stock in accordance with a plan of liquidation, or part of a circular flow of cash. In most cases, the transfer will be treated as a distribution in complete liquidation to which section 336 or 337 applies.

(ii) Tiered targets . In the case of parent-subsidiary chains of corporations making elections under section 338(h)(10), the deemed liquidation of a subsidiary corporation is considered to precede the deemed liquidation of its parent.

(5) Selling consolidated group, selling affiliate, or S corporation shareholders (i) In general . If T is an S corporation target, S corporation shareholders (whether or not they sell their stock) take their pro rata share of the deemed sale gain into account under section 1366 and increase or decrease their basis in T stock under section 1367. Members of the selling consolidated group, the selling affiliate, or S corporation shareholders are treated as if, after the deemed asset sale in paragraph (d)(3) of this section and before the close of the acquisition date, they received the assets transferred by old T in the transaction described in paragraph (d)(4)(i) of this section. In most cases, the transfer will be treated as a distribution in complete liquidation to which section 331 or 332 applies. (ii) Basis and holding period of T stock not acquired . A member of the selling consolidated group (or the selling affiliate or an S corporation shareholder) retaining T stock is treated as acquiring the stock so retained on the day after the acquisition date for its fair market value. The holding period for the retained stock starts on the day after the acquisition date. For purposes of this paragraph, the fair market value of all of the T stock equals the grossed-up amount realized on the sale to P of P’s recently purchased target stock. See §1.338–4T(c).

(iii) T stock sale . Members of the selling consolidated group (or the selling affiliate or S corporation shareholders) recognize no gain or loss on the sale or exchange of T stock included in the qualified stock purchase (although they may recognize gain or loss on the T stock in the deemed liquidation).

January 24, 2000 358 2000–4 I.R.B.

(6) Nonselling minority shareholders other than nonselling S corporation shareholders —(i) In general . This paragraph (d)(6) describes the treatment of shareholders of old T other than the following: members of the selling consolidated group, the selling affiliate, S corporation shareholders (whether or not they sell their stock), and P. For a description of the treatment of S corporation shareholders, see paragraph (d)(5) of this section. A shareholder to which this paragraph (d)(6) applies is called a minority shareholder.

(ii) T stock sale . A minority shareholder recognizes gain or loss on the shareholder’s sale or exchange of T stock included in the qualified stock purchase.

(iii) T stock not acquired . A minority shareholder does not recognize gain or loss under this section with respect to shares of T stock retained by the shareholder. The shareholder’s basis and holding period for that T stock is not affected by the section 338(h)(10) election.

(7) Consolidated return of selling con- solidated group. If P acquires T in a qualified stock purchase from a selling consolidated group—

(i) The selling consolidated group must file a consolidated return for the taxable period that includes the acquisition date;

(ii) A consolidated return for the selling consolidated group for that period may not be withdrawn on or after the day that a section 338(h)(10) election is made for T; and

(iii) Permission to discontinue filing consolidated returns cannot be granted for, and cannot apply to, that period or any of the immediately preceding taxable periods during which consolidated returns continuously have been filed.

(8) Availability of the section 453 in- stallment method . Solely for purposes of applying sections 453, 453A, and 453B, and the regulations thereunder (the installment method) to determine the consequences to old T in the deemed asset sale and to old T (and its shareholders, if relevant) in the deemed liquidation, the rules in paragraphs (d)(1) through (7) of this section are modified as follows:

(i) In deemed asset sale . Old T is treated as receiving in the deemed asset sale new T installment obligations, the terms of which are identical (except as to the obligor) to P installment obligations

issued in exchange for recently purchased stock of T. Old T is treated as receiving in cash all other consideration in the deemed asset sale other than the assumption of, or taking subject to, old T liabilities. For example, old T is treated as receiving in cash any amounts attributable to the grossing-up of amount realized under §1.338–4T(c). The amount realized for recently purchased stock taken into account in determining ADSP is adjusted (and, thus, ADSP is redetermined) to reflect the amounts paid under an installment obligation for the stock when the total payments under the installment obligation are greater or less than the amount realized.

(ii) In deemed liquidation . Old T is treated as distributing in the deemed liquidation the new T installment obligations that it is treated as receiving in the deemed asset sale. The members of the selling consolidated group, the selling affiliate, or the S corporation shareholders are treated as receiving in the deemed liquidation the new T installment obligations that correspond to the P installment obligations they actually received individually in exchange for their recently purchased stock. The new T installment obligations may be recharacterized under other rules. See for example §1.453–11(a)(2) which, in certain circumstances, treats the new T installment obligations deemed distributed by old T as if they were issued by new T in exchange for the members’ of the selling consolidated group, the selling affiliate’s, or the S corporation shareholders’ stock in old T. The members of the selling consolidated group, the selling affiliate, or the S corporation shareholders are treated as receiving all other consideration in the deemed liquidation in cash.

(9) Treatment consistent with an actual asset sale . Old T may not assert any provision in section 338(h)(10) or this section to obtain a tax result that would not be obtained if the parties had actually engaged in the transactions deemed to occur because of this section and taking into account other transactions that actually occurred or are deemed to occur.

(e) Examples . The following examples illustrate this section:

Example 1 . (i) S1 owns all of the T stock and T owns all of the stock of T1 and T2. S1 is the common parent of a consolidated group that includes T, T1, and T2. P makes a qualified stock purchase of all of the T stock from S1. S1 joins with P in making

a section 338(h)(10) election for T and for the deemed purchase of T1. A section 338 election is not made for T2.

(ii) S1 does not recognize gain or loss on the sale of the T stock and T does not recognize gain or loss on the sale of the T1 stock because section 338(h)(10) elections are made for T and T1. Thus, for example, gain or loss realized on the sale of the T or T1 stock is not taken into account in earnings and profits. However, because a section 338 election is not made for T2, T must recognize any gain or loss realized on the deemed sale of the T2 stock. See §1.338–4T(h).

(iii) The results would be the same if S1, T, T1, and T2 are not members of any consolidated group, because S1 and T are selling affiliates.

Example 2. (i) S and T are solvent corporations. S owns all of the outstanding stock of T. S and P agree to undertake the following transaction: T will distribute half its assets to S, and S will assume half of T’s liabilities. Then, P will purchase the stock of T from S. S and P will jointly make a section 338(h)(10) election with respect to the sale of T. The corporations then complete the transaction as agreed.

(ii) Under section 338(a), the assets present in T at the close of the acquisition date are deemed sold by old T to new T. Under paragraph (d)(4) of this section, the transactions described in paragraph (d) of this section are treated in the same manner as if they had actually occurred. Because S and P had agreed that, after T’s actual distribution to S of part of its assets, S would sell T to P pursuant to an election under section 338(h)(10), and because paragraph (d)(4) of this section deems T subsequently to have transferred all its assets to its shareholder, T is deemed to have adopted a plan of complete liquidation under section 332. T’s actual transfer of assets to S is treated as a distribution pursuant to that plan of complete liquidation.

Example 3 . (i) S1 owns all of the outstanding stock of both T and S2. All three are corporations. S1 and P agree to undertake the following transaction. T will transfer substantially all of its assets and liabilities to S2, with S2 issuing no stock in exchange therefor, and retaining its other assets and liabilities. Then, P will purchase the stock of T from S1. S1 and P will jointly make a section 338(h)(10) election with respect to the sale of T. The corporations then complete the transaction as agreed.

(ii) Under section 338(a), the assets present in T at the close of the acquisition date are deemed sold by old T to new T. Under paragraph (d)(4) of this section, the transactions described in this section are treated in the same manner as if they had actually occurred. Because old T transferred substantially all of its assets to S2, and is deemed to have distributed all its remaining assets and gone out of existence, the transfer of assets to S2, taking into account the related transfers, deemed and actual, qualifies as a reorganization under section 368(a)(1)(D). Section 361(c)(1) and not section 332 applies to T’s deemed liquidation.

Example 4 . (i) T owns two assets: an actively traded security (Class II) with a fair market value of $100 and an adjusted basis of $100, and inventory (Class IV) with a fair market value of $100 and an adjusted basis of $100. T has no liabilities. S is negotiating to sell all the stock in T to P for $100 cash and contingent consideration. Assume that under generally applicable tax accounting rules, P’s ad

2000–4 I.R.B. 359 January 24, 2000

justed basis in the T stock immediately after the purchase would be $100, because the contingent consideration is not taken into account. Thus, under the rules of §1.338–5T, AGUB would be $100. Under the allocation rules of §1.338–6T, the entire $100 would be allocated to the Class II asset, the actively traded security, and no amount would be allocated to the inventory. P, however, plans immediately to cause T to sell the inventory, but not the actively traded security, so it requests that, prior to the stock sale, S cause T to create a new subsidiary, Newco, and contribute the actively traded security to the capital of Newco. Because the stock in Newco, which would not be actively traded, is a Class V asset, under the rules of §1.338–6T $100 of AGUB would be allocated to the inventory and no amount of AGUB would be allocated to the Newco stock. Newco’s own AGUB, $0 under the rules of §1.338–5T, would be allocated to the actively traded

is allocated to each asset as follows:

security. When P subsequently causes T to sell the inventory, T would realize no gain or loss instead of realizing gain of $100.

(ii) Assume that, if the T stock had not itself been sold but T had instead sold both its inventory and the Newco stock to P, T would for tax purposes be deemed instead to have sold both its inventory and actively traded security directly to P, with P deemed then to have created Newco and contributed the actively traded security to the capital of Newco. Section 338, if elected, generally recharacterizes a stock sale as a deemed sale of assets. The tax results of the deemed sale of assets should, where possible, be like those of an actual asset sale. Hence, the deemed sale of assets under section 338(h)(10) should be treated as one of the inventory and actively traded security themselves, not of the inventory and Newco stock. That is the substance of the transaction. The anti-abuse rule of §1.338–1T(c) does not apply, be

cause the substance of the deemed sale of assets is a sale of the inventory and the actively traded security themselves, not of the inventory and the Newco stock. Otherwise, the anti-abuse rule might apply.

Example 5 . (i) T, a member of a selling consolidated group, has only one class of stock, all of which is owned by S1. On March 1 of Year 2, S1 sells its T stock to P for $80,000, and joins with P in making a section 338(h)(10) election for T. There are no selling costs or acquisition costs. On March 1 of Year 2, T owns land with a $50,000 basis and $75,000 fair market value and equipment with a $30,000 adjusted basis, $70,000 recomputed basis, and $60,000 fair market value. T also has a $40,000 liability. S1 pays old T’s allocable share of the selling group’s consolidated tax liability for Year 2 including the tax liability for the deemed sale gain (a total of $13,600).

(ii) ADSP of $120,000 ($80,000 + $40,000 + 0)

Assets Basis FMV Fraction Allocable

ADSP

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000 $ 75,000 5/9 $ 66,667

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 60,000 4/9 53,333

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 135,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 120,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(iii) Under paragraph (d)(3) of this section, old T has gain on the deemed sale of $40,000 (consisting of $16,667 of capital gain and $23,333 of ordinary income).

(iv) Under paragraph (d)(5)(iii) of this section, S1 recognizes no gain or loss upon its sale of the old T stock to P. S1 also recognizes no gain or loss upon the deemed liquidation of T. See paragraph (d)(4) of this section and section 332.

(v) P’s basis in new T stock is P’s cost for the stock, $80,000. See section 1012.

(vi) Under §1.338–5T, the AGUB for new T is $120,000, i.e., P’s cost for the old T stock ($80,000) plus T’s liability ($40,000). This AGUB is allocated as basis among the new T assets under §§1.338–6T and 1.338–7T.

Example 6 . (i) The facts are the same as in Ex- ample 5, except that S1 sells 80 percent of the old T stock to P for $64,000, rather than 100 percent of the old T stock for $80,000.

(ii) The consequences to P, T, and S1 are the same as in Example 5, except that:

(A) P’s basis for its 80-percent interest in the new T stock is P’s $64,000 cost for the stock. See section 1012. (B) Under §1.338–5T, the AGUB for new T is $120,000 (i.e., $64,000/.8 + $40,000 + $0).

(C) Under paragraph (d)(4) of this section, S1 recognizes no gain or loss with respect to the retained stock in T. See section 332.

(D) Under paragraph (d)(5)(ii) of this section, the basis of the T stock retained by S1 is $16,000 (i.e., $120,000 å $40,000 (the ADSP amount for the old T assets over the sum of new T’s liabilities immediately after the acquisition date) ( .20 (the proportion of T stock retained by S1)).

Example 7 . (i) The facts are the same as in Ex- ample 6, except that K, a shareholder unrelated to T

or P, owns the 20 percent of the T stock that is not acquired by P in the qualified stock purchase. K’s basis in its T stock is $5,000.

(ii) The consequences to P, T, and S1 are the same as in Example 6 .

(iii) Under paragraph (d)(6)(iii) of this section, K recognizes no gain or loss, and K’s basis in its T stock remains at $5,000.

Example 8 . (i) The facts are the same as in Ex- ample 5, except that the equipment is held by T1, a wholly–owned subsidiary of T, and a section 338(h)(10) election is also made for T1. The T1 stock has a fair market value of $60,000. T1 has no assets other than the equipment and no liabilities. S1 pays old T’s and old T1’s allocable shares of the selling group’s consolidated tax liability for Year 2 including the tax liability for T and T1’s deemed sale gain.

(ii) ADSP for T is $120,000, allocated $66,667 to the land and $53,333 to the stock. Old T’s deemed sale gain is $16,667 (the capital gain on its deemed sale of the land). Under paragraph (d)(5)(iii) of this section, old T does not recognize gain or loss on its deemed sale of the T1 stock. See section 332.

(iii) ADSP for T1 is $53,333 (i.e., $53,333 + $0 + $0). On the deemed sale of the equipment, T1 recognizes ordinary income of $23,333.

(iv) Under paragraph (d)(5)(iii) of this section, S1 does not recognize gain or loss upon its sale of the old T stock to P.

Example 9 . (i) The facts are the same as in Ex- ample 8, except that P already owns 20 percent of the T stock, which is nonrecently purchased stock with a basis of $6,000, and that P purchases the remaining 80 percent of the T stock from S1 for $64,000.

(ii) The results are the same as in Example 8, except that under paragraph (d)(1) of this section and §1.338-5T(d), P is deemed to have made a gain recognition election for its nonrecently purchased T stock. As a result, P recognizes gain of $10,000 and its basis in the nonrecently purchased T stock is increased from $6,000 to $16,000. P’s basis in all the T stock is $80,000 (i.e., $64,000 + $16,000). The

computations are as follows:

(A) P’s grossed-up basis for the recently purchased T stock is $64,000 (i.e., $64,000 (the basis of the recently purchased T stock) ( (1 å .2)/(.8) (the fraction in section 338(b)(4))).

(B) P’s basis amount for the nonrecently purchased T stock is $16,000 (i.e., $64,000 (the grossed-up basis in the recently purchased T stock) ( (.2)/(1.0 å .2) (the fraction in section 338(b)(3)(B))).

(C) The gain recognized on the nonrecently purchased stock is $10,000 (i.e., $16,000 å $6,000).

Example 10 . (i) T is an S corporation whose sole class of stock is owned 40 percent each by A and B and 20 percent by C. T, A, B, and C all use the cash method of accounting. A and B each has an adjusted basis of $10,000 in the stock. C has an adjusted basis of $5,000 in the stock. A, B, and C hold no installment obligations to which section 453A applies. On March 1 of Year 1, A sells its stock to P for $40,000 in cash and B sells its stock to P for a $25,000 note issued by P and real estate having a fair market value of $15,000. The $25,000 note, due in full in Year 7, is not publicly traded and bears adequate stated interest. A and B have no selling expenses. T’s sole asset is real estate, which has a value of $110,000 and an adjusted basis of $35,000. Also, T’s real estate is encumbered by long-outstanding purchase-money indebtedness of $10,000. The real estate does not have built-in gain subject to section 1374. A, B, and C join with P in making a section 338(h)(10) election for T.

(ii) Solely for purposes of application of sections 453, 453A, and 453B, old T is considered in its deemed asset sale to receive back from new T the $25,000 note (considered issued by new T) and $75,000 of cash (total consideration of $80,000 paid for all the stock sold, which is then divided by .80 in the grossing-up, with the resulting figure of $100,000 then reduced by the amount of the installment note). Absent an election under section 453(d), gain is reported by old T under the installment method.

(iii) In applying the installment method to old T’s deemed asset sale, the contract price for old T’s as

January 24, 2000 360 2000–4 I.R.B.

fore January 5, 2000, see §1.1060–1T in effect prior to January 6, 2000 (see 26 CFR part 1 revised April 1, 1999).

(3) Outline of topics . In order to facilitate the use of this section, this paragraph (a)(3) lists the major paragraphs in this section as follows: (a) Scope. (1) In general. (2) Effective date. (3) Outline of topics. (b) Applicable asset acquisition. (1) In general. (2) Assets constituting a trade or business. (i) In general. (ii) Goodwill or going concern value. (iii) Factors indicating goodwill or going concern value. (3) Examples. (4) Asymmetrical transfers of assets. (5) Related transactions. (6) More than a single trade or business. (7) Covenant entered into by the seller. (8) Partial non-recognition exchanges. (c) Allocation of consideration among assets under the residual method. (1) Consideration. (2) Allocation of consideration among assets. (3) Certain costs. (4) Effect of agreement between parties. (d) Examples. (e) Reporting requirements. (1) Applicable asset acquisitions. (i) In general. (ii) Time and manner of reporting. (A) In general. (B) Additional reporting requirement. (2) Transfers of interests in partnerships.

(b) Applicable asset acquisition —(1) In general. An applicable asset acquisition is any transfer, whether direct or indirect, of a group of assets if the assets transferred constitute a trade or business in the hands of either the seller or the purchaser and, except as provided in paragraph (b)(8) of this section, the purchaser’s basis in the transferred assets is determined wholly by reference to the purchaser’s consideration.

(2) Assets constituting a trade or busi- ness —(i) In general . For purposes of this section, a group of assets constitutes a trade or business if—

(A) The use of such assets would constitute an active trade or business under section 355; or

(B) Its character is such that goodwill

sets deemed sold is $100,000, the $110,000 selling price reduced by the indebtedness of $10,000 to which the assets are subject. (The $110,000 selling price is itself the sum of the $80,000 grossed-up in paragraph (ii) above to $100,000 and the $10,000 liability.) Gross profit is $75,000 ($110,000 selling price å old T’s basis of $35,000). Old T’s gross profit ratio is 0.75 (gross profit of $75,000 â $100,000 contract price). Thus, $56,250 (0.75 ( the $75,000 cash old T is deemed to receive in Year 1) is Year 1 gain attributable to the sale, and $18,750 ($75,000 å $56,250) is recovery of basis.

(iv) In its liquidation, old T is deemed to distribute the $25,000 note to B, since B actually sold the stock partly for that consideration. To the extent of the remaining liquidating distribution to B, it is deemed to receive, along with A and C, the balance of old T’s liquidating assets in the form of cash. Under section 453(h), B, unless it makes an election under section 453(d), is not required to treat the receipt of the note as a payment for the T stock; P’s payment of the $25,000 note in Year 7 to B is a payment for the T stock. Because section 453(h) applies to B, old T’s deemed liquidating distribution of the note is, under section 453B(h), not treated as a taxable disposition by old T.

(v) Under section 1366, A reports 40 percent, or $22,500, of old T’s $56,250 gain recognized in Year

1. Under section 1367, this increases A’s $10,000 adjusted basis in the T stock to $32,500. Next, in old T’s deemed liquidation, A is considered to receive $40,000 for its old T shares, causing it to recognize an additional $7,500 gain in Year 1.

(vi) Under section 1366, B reports 40 percent, or $22,500, of old T’s $56,250 gain recognized in Year

1. Under section 1367, this increases B’s $10,000 adjusted basis in its T stock to $32,500. Next, in old T’s deemed liquidation, B is considered to receive the $25,000 note and $15,000 of other consideration. Applying section 453, including section 453(h), to the deemed liquidation, B’s selling price and contract price are both $40,000. Gross profit is $7,500 ($40,000 selling price å B’s basis of $32,500). B’s gross profit ratio is 0.1875 (gross profit of $7,500 â $40,000 contract price). Thus, $2,812.50 (0.1875 ( $15,000) is Year 1 gain attributable to the deemed liquidation. In Year 7, when the $25,000 note is paid, B has $4,687.50 (0.1875 ( $25,000) of additional gain.

(vii) Under section 1366, C reports 20 percent, or $11,250, of old T’s $56,250 gain recognized in Year

1. Under section 1367, this increases C’s $5,000 adjusted basis in its T stock to $16,250. Next, in old T’s deemed liquidation, C is considered to receive $20,000 for its old T shares, causing it to recognize an additional $3,750 gain in Year 1. Finally, under paragraph (d)(5)(ii) of this section, C is considered to acquire its stock in T on the day after the acquisition date for $20,000 (fair market value = grossedup amount realized of $100,000 ( 20%). C’s holding period in the stock deemed received in new T begins at that time.

(f) Inapplicability of provisions. The provisions of section 6043, §1.331– 1(d), and §1.332–6 (relating to information returns and recordkeeping requirements for corporate liquidations) do not apply to the deemed liquidation of old T under paragraph (d)(4) of this section.

(g) Required information . The Commissioner may exercise the authority granted in section 338(h)(10)(C)(iii) to require provision of any information deemed necessary to carry out the provisions of section 338(h)(10) by requiring submission of information on any tax reporting form.

§1.338(i)–1 [Removed]

Par. 11. Section 1.338(i)–1 is removed. Par. 12. Section 1.338(i)–1T is added to read as follows: §1.338(i)–1T Effective dates (temporary).

The provisions of §§1.338–0T through 1.338–7T, 1.338–10T and 1.338(h)(10)–1T apply to any qualified stock purchase occurring after January 5, 2000. For rules applicable to qualified stock purchases on or before January 5, 2000, see §§1.338–0 through 1.338–5, 1.338(b)–1, 1.338(b)–2T, 1.338(b)–3T, 1.338(h)(10)–1, and 1.338(i)–1 in effect prior to January 6, 2000 (see 26 CFR part 1 revised April 1, 1999). Par. 13. Section 1.1060–1T is revised to read as follows: §1.1060–1T Special allocation rules for certain asset acquisitions (temporary).

(a) Scope —(1) In general . This section prescribes rules relating to the requirements of section 1060, which, in the case of an applicable asset acquisition, requires the transferor (the seller) and the transferee (the purchaser) each to allocate the consideration paid or received in the transaction among the assets transferred in the same manner as amounts are allocated under section 338(b)(5) (relating to the allocation of adjusted grossed-up basis among the assets of the target corporation when a section 338 election is made). In the case of an applicable asset acquisition described in paragraph (b)(1) of this section, sellers and purchasers must allocate the consideration under the residual method as described in §§1.338–6T and 1.338–7T in order to determine, respectively, the amount realized from, and the basis in, each of the transferred assets. For rules relating to distributions of partnership property or transfers of partnership interests which are subject to section 1060(d), see §1.755–2T.

(2) Effective date . The provisions of this section apply to any asset acquisition occurring after January 5, 2000. For rules applicable to asset acquisitions on or be

2000–4 I.R.B. 361 January 24, 2000

acquiring, the assets acquired by the purchaser constitute a trade or business, and, except as provided in paragraph (b)(8) of this section, the purchaser’s basis in the transferred assets is determined wholly by reference to the purchaser’s consideration, then the purchaser is subject to section 1060.

(5) Related transactions. Whether the assets transferred constitute a trade or business is determined by aggregating all transfers from the seller to the purchaser in a series of related transactions. Except as provided in paragraph (b)(8) of this section, all assets transferred from the seller to the purchaser in a series of related transactions are included in the group of assets among which the consideration paid or received in such series is allocated under the residual method. The principles of §1.338–1T(c) are also applied in determining which assets are included in the group of assets among which the consideration paid or received is allocated under the residual method.

(6) More than a single trade or busi- ness. If the assets transferred from a seller to a purchaser include more than one trade or business, then, in applying this section, all of the assets transferred (whether or not transferred in one transaction or a series of related transactions and whether or not part of a trade or business) are treated as a single trade or business.

(7) Covenant entered into by the seller . If, in connection with an applicable asset acquisition, the seller enters into a covenant (e.g., a covenant not to compete) with the purchaser, that covenant is treated as an asset transferred as part of a trade or business.

(8) Partial non-recognition exchanges . A transfer may constitute an applicable asset acquisition notwithstanding the fact that no gain or loss is recognized with respect to a portion of the group of assets transferred. All of the assets transferred, including the non-recognition assets, are taken into account in determining whether the group of assets constitutes a trade or business. The allocation of consideration under paragraph (c) of this section is done without taking into account either the non-recognition assets or the amount of money or other property that is treated as transferred in exchange for the non-recog

or going concern value could under any circumstances attach to such group.

(ii) Goodwill or going concern value. Goodwill is the value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor. Going concern value is the additional value that attaches to property because of its existence as an integral part of an ongoing business activity. Going concern value includes the value attributable to the ability of a trade or business (or a part of a trade or business) to continue functioning or generating income without interruption notwithstanding a change in ownership. It also includes the value that is attributable to the immediate use or availability of an acquired trade or business, such as, for example, the use of the revenues or net earnings that otherwise would not be received during any period if the acquired trade or business were not available or operational.

(iii) Factors indicating goodwill or going concern value. In making the determination in this paragraph (b)(2), all the facts and circumstances surrounding the transaction are taken into account. Whether sufficient consideration is available to allocate to goodwill or going concern value after the residual method is applied is not relevant in determining whether goodwill or going concern value could attach to a group of assets. Factors to be considered include—

(A) The presence of any intangible assets (whether or not those assets are section 197 intangibles), provided, however, that the transfer of such an asset in the absence of other assets will not be a trade or business for purposes of section 1060;

(B) The existence of an excess of the total consideration over the aggregate book value of the tangible and intangible assets purchased (other than goodwill and going concern value) as shown in the financial accounting books and records of the purchaser; and

(C) Related transactions, including lease agreements, licenses, or other similar agreements between the purchaser and seller (or managers, directors, owners, or employees of the seller) in connection with the transfer.

(3) Examples . The following examples illustrate paragraphs (b)(1) and (2)

of this section:

Example 1 . S is a high grade machine shop that manufactures microwave connectors in limited quantities. It is a successful company with a reputation within the industry and among its customers for manufacturing unique, high quality products. Its tangible assets consist primarily of ordinary machinery for working metal and plating. It has no secret formulas or patented drawings of value. P is a company that designs, manufactures, and markets electronic components. It wants to establish an immediate presence in the microwave industry, an area in which it previously has not been engaged. P is acquiring assets of a number of smaller companies and hopes that these assets will collectively allow it to offer a broad product mix. P acquires the assets of S in order to augment its product mix and to promote its presence in the microwave industry. P will not use the assets acquired from S to manufacture microwave connectors. The assets transferred are assets that constitute a trade or business in the hands of the seller. Thus, P’s purchase of S’s assets is an applicable asset acquisition. The fact that P will not use the assets acquired from S to continue the business of S does not affect this conclusion.

Example 2 . S, a sole proprietor who operates a car wash, both leases the building housing the car wash and sells all of the car wash equipment to P. S’s use of the building and the car wash equipment constitute a trade or business. P begins operating a car wash in the building it leases from S. Because the assets transferred together with the asset leased are assets which constitute a trade or business, P’s purchase of S’s assets is an applicable asset acquisition.

Example 3 . S, a corporation, owns a retail store business in State X and conducts activities in connection with that business enterprise that meet the active trade or business requirement of section 355. P is a minority shareholder of S. S distributes to P all the assets of S used in S’s retail business in State X in complete redemption of P’s stock in S held by P. The distribution of S’s assets in redemption of P’s stock is treated as a sale or exchange under sections 302(a) and 302(b)(3), and P’s basis in the assets distributed to it is determined wholly by reference to the consideration paid, the S stock. Thus, S’s distribution of assets constituting a trade or business to P is an applicable asset acquisition.

Example 4 . S is a manufacturing company with an internal financial bookkeeping department. P is in the business of providing a financial bookkeeping service on a contract basis. As part of an agreement for P to begin providing financial bookkeeping services to S, P agrees to buy all of the assets associated with S’s internal bookkeeping operations and provide employment to any of S’s bookkeeping department employees who choose to accept a position with P. In addition to selling P the assets associated with its bookkeeping operation, S will enter into a long term contract with P for bookkeeping services. Because assets transferred from S to P, along with the related contract for bookkeeping services, are a trade or business in the hands of P, the sale of the bookkeeping assets from S to P is an applicable asset acquisition.

(4) Asymmetrical transfers of assets . If, under general principles of tax law, a seller is not treated as transferring the same assets as the purchaser is treated as

January 24, 2000 362 2000–4 I.R.B.

nition assets (together, the non-recognition exchange property). The basis in and gain or loss recognized with respect to the non-recognition exchange property are determined under such rules as would otherwise apply to an exchange of such property. The amount of the money and other property treated as exchanged for non-recognition assets is the amount by which the fair market value of the nonrecognition assets transferred by one party exceeds the fair market value of the non-recognition assets transferred by the other (to the extent of the money and the fair market value of property transferred in the exchange). The money and other property that are treated as transferred in exchange for the non-recognition assets (and which are not included among the assets to which section 1060 applies) are considered to come from the following assets in the following order: first from Class I assets, then from Class II assets, then from Class III assets, then from Class IV assets, then from Class V assets, then from Class VI assets, and then from Class VII assets. For this purpose, liabilities assumed (or to which a non-recognition exchange property is subject) are treated as Class I assets. See Example 1 in paragraph (d) of this section for an example of the application of section 1060 to a single transaction which is, in part, a non-recognition exchange.

(c) Allocation of consideration among assets under the residual method - (1) Consideration. The seller’s consideration is the amount, in the aggregate, realized from selling the assets in the applicable asset acquisition under section 1001(b).

The purchaser’s consideration is the amount, in the aggregate, of its cost of purchasing the assets in the applicable asset acquisition that is properly taken into account in basis.

(2) Allocation of consideration among assets . For purposes of determining the seller’s amount realized for each of the assets sold in an applicable asset acquisition, the seller allocates consideration to all the assets sold by using the residual method under §§1.338–6T and 1.338–7T, substituting consideration for ADSP. For purposes of determining the purchaser’s basis in each of the assets purchased in an applicable asset acquisition, the purchaser allocates consideration to all the assets purchased by using the residual method under §§1.338–6T and 1.338–7T, substituting consideration for AGUB. In allocating consideration, the rules set forth in paragraphs (c)(3) and (4) of this section apply in addition to the rules in §§1.338–6T and 1.338–7T.

(3) Certain costs. The seller and purchaser each adjusts the amount allocated to an individual asset to take into account the specific identifiable costs incurred in transferring that asset in connection with the applicable asset acquisition (e.g., real estate transfer costs or security interest perfection costs). Costs so allocated increase, or decrease, as appropriate, the total consideration that is allocated under the residual method. No adjustment is made to the amount allocated to an individual asset for general costs associated with the applicable asset acquisition as a whole or with groups of assets included therein (e.g., non-specific appraisal fees

or accounting fees). These latter amounts are taken into account only indirectly through their effect on the total consideration to be allocated.

(4) Effect of agreement between parties . If, in connection with an applicable asset acquisition, the seller and purchaser agree in writing as to the allocation of any amount of consideration to, or as to the fair market value of, any of the assets, such agreement is binding on them to the extent provided in this paragraph (c)(4). Nothing in this paragraph (c)(4) restricts the Commissioner’s authority to challenge the allocations or values arrived at in an allocation agreement. This paragraph (c)(4) does not apply if the parties are able to refute the allocation or valuation under the standards set forth in Com- missioner v. Danielson, 378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967) (a party wishing to challenge the tax consequences of an agreement as construed by the Commissioner must offer proof that, in an action between the parties to the agreement, would be admissible to alter that construction or show its unenforceability because of mistake, undue influence, fraud, duress, etc.).

(d) Examples. The following examples illustrate this section:

Example 1 . (i) On January 1, 2001, A transfers assets X, Y, and Z to B in exchange for assets D, E, and F plus $1,000 cash.

(ii) Assume the exchange of assets constitutes an exchange of like-kind property to which section 1031 applies. Assume also that goodwill or going concern value could under any circumstances attach to each of the DEF and XYZ groups of assets and, therefore, each group constitutes a trade or business under section 1060.

(iii) Assume the fair market values of the assets and the amount of money transferred are as follows:

By A By B Asset Fair Market Value Asset Fair Market Value

X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400 D . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40

Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 E . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Z . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 F . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Cash (amount) . . . . . . . . . . . . . . . . . 1,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000 Total. . . . . . . . . . . . . . . . . . . . . . . $ 1,100

(iv) Under paragraph (b)(8) of this section, for purposes of allocating consideration under paragraph (c) of this section, the like-kind assets exchanged and any money or other property that are treated as transferred in exchange for the like-kind property are excluded from the application of section 1060.

(v) Since assets X, Y, and Z are like-kind property, they are excluded from the application of the section 1060 allocation rules.

(vi) Since assets D, E, and F are like-kind property, they are excluded from the application of the section 1060 allocation rules. In addition, $900 of the $1,000 cash B gave to A for A’s like-kind assets is treated as transferred in exchange for the like-kind property in order to equalize the fair market values of the like-kind assets. Therefore, $900 of the cash is excluded from the application of the section 1060 allocation rules.

(vii) $100 of the cash is allocated under section

1060 and paragraph (c) of this section. (viii) A, as transferor of assets X, Y, and Z, received $100 that must be allocated under section 1060 and paragraph (c) of this section. Since A transferred no Class I, II, III, IV, V, or VI assets to which section 1060 applies, in determining its amount realized for the part of the exchange to which section 1031 does not apply, the $100 is allocated to Class VII assets (goodwill and going concern value).

2000–4 I.R.B. 363 January 24, 2000

(ix) A, as transferee of assets D, E, and F, gave consideration only for assets to which section 1031 applies. Therefore, the allocation rules of section 1060 and paragraph (c) of this section are not applied to determine the bases of the assets A received.

(x) B, as transferor of assets D, E, and F, received consideration only for assets to which section 1031 applies. Therefore, the allocation rules of section 1060 do not apply in determining B’s gain or loss. (xi) B, as transferee of assets X, Y, and Z, gave A $100 that must be allocated under section 1060 and paragraph (c) of this section. Since B received from A no Class I, II, III, IV, V, or VI assets to which section 1060 applies, the $100 consideration is allocated by B to Class VII assets (goodwill and going concern value).

Example 2. (i) On January 1, 2001, S, a sole proprietor, sells to P, a corporation, a group of assets that constitutes a trade or business under paragraph (b)(2) of this section. S, who plans to retire immediately, also executes in P’s favor a covenant not to compete. P pays S $3,000 in cash and assumes $1,000 in liabilities. Thus, the total consideration is $4,000.

(ii) On the purchase date, P and S also execute a separate agreement that states that the fair market values of the Class II, Class III, Class V, and Class VI assets S sold to P are as follows: Asset Asset Fair Class Market

Value

II Actively traded securities . . . . . $ 500

Total Class II . . . . . . . . . . . 500

III Accounts receivable . . . . . . . . . 200

Total Class III . . . . . . . . . . . 200

V Furniture and fixtures . . . . . . . . 800

Building . . . . . . . . . . . . . . . . . . 800

Land . . . . . . . . . . . . . . . . . . . . . 200

Equipment . . . . . . . . . . . . . . . . . 400

Total Class V . . . . . . . . . . . 2,200

VI Covenant not to compete . . . . . 900

Total Class VI . . . . . . . . . . 900 (iii) P and S each allocate the consideration in the transaction among the assets transferred under paragraph (c) of this section in accordance with the agreed upon fair market values of the assets, so that $500 is allocated to Class II assets, $200 is allocated to the Class III asset, $2,200 is allocated to Class V assets, $900 is allocated to Class VI assets, and $200

($4,000 total consideration less $3,800 allocated to assets in Classes II, III, V, and VI) is allocated to the Class VII assets (goodwill and going concern value).

(iv) In connection with the examination of P’s return, the District Director, in determining the fair market values of the assets transferred, may disregard the parties’ agreement. Assume that the District Director correctly determines that the fair market value of the covenant not to compete was $500. Since the allocation of consideration among Class II, III, V, and VI assets results in allocation up to the fair market value limitation, the $600 of unallocated consideration resulting from the District Director’s redetermination of the value of the covenant not to compete is allocated to Class VII assets (goodwill and going concern value).

(e) Reporting requirements —(1) Applic- able asset acquisitions —(i) In general . Unless otherwise excluded from this requirement by the Commissioner, the seller and the purchaser in an applicable asset acquisition each must report information concerning the amount of consideration in the transaction and its allocation among the assets transferred. They also must report information concerning subsequent adjustments to consideration.

(ii) Time and manner of reporting —(A) In general . The seller and the purchaser each must file asset acquisition statements on Form 8594 with their income tax returns or returns of income for the taxable year that includes the first date assets are sold pursuant to an applicable asset acquisition. This reporting requirement applies to all asset acquisitions described in this section. For reporting requirements relating to asset acquisitions occurring before January 6, 2000, as described in paragraph (a)(2) of this section, see the temporary regulations under section 1060 in effect prior to January 6, 2000 (§1.1060–1T as contained in 26 CFR part 1 revised April 1, 1999).

(B) Additional reporting requirement . When an increase or decrease in consideration is taken into account after the close of

the first taxable year that includes the first date assets are sold in an applicable asset acquisition, the seller and the purchaser each must file a supplemental asset acquisition statement on Form 8594 with the income tax return or return of income for the taxable year in which the increase (or decrease) is properly taken into account.

(2) Transfers of interests in partner- ships. For reporting requirements relating to the transfer of a partnership interest, see §1.755–2T(c).

PART 602—OMB CONTROL NUMBERS UNDER PAPERWORK REDUCTION ACT

Par. 14. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 15. In §602.101, paragraph (b) is amended by removing the entries for §§1.338–1, 1.338(b)–1, 1.338(h)(10)–1, and 1.1060–1T from the tables and adding new entries to the table in numerical order to read as follows: §602.101 OMB Control numbers.

• ---

(b) * * *

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

Approved December 22, 1999.

Jonathan Talisman, Acting Assistant Secretary of the

Treasury.

(Filed by the Office of the Federal Register on January 5, 2000, 8:45 a.m., and published in the issue of the Federal Register for January 7, 2000, 65 F.R. 1235)

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

• ---

1.338–2T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1658 1.338–5T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1658 1.338–10T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1658 1.338–(h)(10)–1T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1658

• ---

January 24, 2000 364 2000–4 I.R.B.

portion of the gross premium allocable to future insurance claims but also the portion allocable to the insurance company’s expenses and profit on the insurance contract.

In 1986, Congress determined that deferring unearned premium income and currently deducting premium acquisition expenses attributable to unearned premiums resulted in a mismatch of an insurance company’s net income and expense. Congress decided to require a better measurement of net income for Federal income tax purposes. See H.R. Rep. No. 426, 1986–3 C.B. (Vol. 2) at 669; S. Rep. No. 313, 1986–3 C.B. (Vol. 3) at 496. Rather than defer the deduction for premium acquisition expenses attributable to unearned premiums, Congress reduced by 20 percent the adjustment for unearned premiums. For taxable years beginning on or after January 1, 1993, a non-life insurance company’s premiums earned is an amount equal to: (1) its gross premiums written, less both return premiums and premiums paid for reinsurance; plus (2) 80 percent of unearned premiums at the end of the prior taxable year, less 80 percent of unearned premiums at the end of the current taxable year. Section 832(b)(4). The acceleration of income that is typically generated by the 20 percent reduction of unearned premiums is intended to be roughly equivalent to denying current deductibility for the portion of the insurance company’s premium acquisition expenses allocable to the unearned premiums. See 2 H.R. Conf. Rep. No. 841, 1986–3 C.B. (Vol. 4) at 354–55; S. Rep. No. 313, 1986–3 C.B. (Vol. 3) at 495–98; H.R. Rep. No. 426, 1986–3 C.B. (Vol. 2) at 668–70.

Role of the annual statement

The proposed regulations provide definitions of the items used to determine premiums earned under section 832(b)(4) and timing rules for taking these items into account for Federal income tax purposes. The treatment provided in the proposed regulations would apply regardless of the classification or method of reporting the items used on an insurance company’s annual statement.

Several comments questioned whether there is legal authority to require an insurance company to use a method to cal

Section 832.—Insurance Company Taxable Income

26 CFR 1.832–4: Gross Income.

T.D. 8857

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Determination of Underwriting Income

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the determination of underwriting income by insurance companies other than life insurance companies. In computing underwriting income, non-life insurance companies are required to reduce by 20 percent their deductions for increases in unearned premiums. This requirement was enacted as part of the Tax Reform Act of 1986. These regulations provide guidance to non-life insurance companies for purposes of determining the amount of unearned premiums that are subject to the 20 percent reduction rule.

DATES: The regulations are effective January 5, 2000 .

FOR FURTHER INFORMATION CONTACT: Gary Geisler, (202) 622-3970 (not a toll-free number)

SUPPLEMENTARY INFORMATION:

Background

On January 2, 1997, the IRS published in the Federal Register a notice of proposed rulemaking (REG–209839–96, 1997–1 C.B. 780 [62 F.R. 72]) proposing amendments to the Income Tax Regulations (26 CFR part 1) under section 832(b) of the Internal Revenue Code. The IRS received a number of written comments on the proposed regulations. On April 30, 1997, the IRS held a public hearing on the proposed regulations. After consideration of all written and oral

comments regarding the proposed regulations, those regulations are adopted as revised by this Treasury decision.

Explanation of Revisions and Summary of Comments

Underwriting income

A non-life insurance company’s underwriting income equals its premiums earned on insurance contracts during the taxable year less its losses incurred on insurance contracts and its expenses incurred. ¹ See section 832(b)(3). To compute premiums earned, the company starts with the gross premiums written on insurance contracts during the taxable year, subtracts return premiums and premiums paid for reinsurance, and makes an adjustment to reflect the change in its unearned premiums over the course of the taxable year. See section 832(b)(4). This computation results in premiums being recognized in underwriting income over the term of the insurance contract, rather than in the taxable year in which the premiums are billed or received from the policyholder.

Prior to 1987, 100 percent of the change in unearned premiums during the taxable year was taken into account as an increase or decrease to written premiums in computing premiums earned. This treatment “generally reflect[ed]” the accounting conventions (often referred to as “statutory accounting principles”) used to prepare a non-life insurance company’s annual statement for state insurance regulatory purposes. See 2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-354 (1986), 1986–3 C.B. (Vol. 4) 354; S. Rep. No. 313, 99th Cong., 2d Sess. 495 (1986), 1986–3 C.B. (Vol. 3) 495, H.R. Rep. No. 426, 99th Cong., 1st Sess. 668 (1985), 1986–3 C.B. (Vol. 2) 668. Because unearned premiums are computed on the basis of the gross premiums for an insurance contract, the amount of unearned premiums reflects not only the

1For this purpose, expenses incurred generally refers to the expenses reported on the company’s annual statement approved by the National Association of Insurance Commissioners (NAIC) and filed for state insurance regulatory purposes, less expenses incurred which are not allowed as deductions under section 832(c). See section 832(b)(6). Expenses incurred generally include premium acquisition expenses attributable to unearned premiums on insurance contracts.

2000–4 I.R.B. 365 January 24, 2000

culate premiums earned for Federal income tax purposes that differs from the method that the company is permitted to use to calculate premiums earned on its annual statement. As noted in the preamble to the proposed regulations, the existing regulations under §1.832–4(a)(2) state that the annual statement “. . . insofar as it is not inconsistent with the provisions of the Code . . .” will be recognized and used as a basis for computing the net income of a nonlife insurance company. Also, if statutory accounting principles permit alternative practices, one or more of which do not clearly reflect income as defined by the Code, the company is required for Federal income tax purposes to use a method that clearly reflects income. Section 446(b) and §1.446–1(a)(2).

Gross premiums written

The proposed regulations generally define gross premiums written as the total amounts payable for insurance coverage under insurance or reinsurance contracts issued or renewed during the taxable year. The proposed regulations, however, do not address situations where the amounts charged for insurance coverage may change due to increases or decreases in coverage limits, additions or deletions in property or risks covered, changes in location or status of insureds, or other similar factors.

The final regulations define an insurance company’s “gross premiums written” on insurance contracts (which includes premiums attributable to reinsurance contracts) as amounts payable for insurance coverage for the effective periods of the contracts. The label placed on a payment in a contract does not determine whether an amount is a gross premiums written. The effective period of a contract is the period over which one or more rates for insurance coverage are guaranteed in the contract. If a new rate for insurance coverage is guaranteed after the effective date of an insurance contract, the making of the guarantee generally is treated as the issuance of a new insurance contract with an effective period equal to the duration of the new guaranteed rate for insurance coverage.

Under the final regulations, gross premiums written include: (1) additional

premiums resulting from increases in risk exposure during the effective period of an insurance contract; (2) amounts subtracted from a premium stabilization reserve that are used to pay premiums; and (3) consideration for assuming insurance liabilities under contracts not issued by the insurance company (that is, a payment or transfer of property in an assumption reinsurance transaction). Gross premiums written, however, do not include other items of gross income described in section 832(b)(1)(C). To the extent that amounts paid or payable to an insurance company with respect to an arrangement are not gross premiums written, the insurance company may not treat amounts payable to customers with respect to the applicable portion of such arrangements as losses incurred described in section 832(b)(5).

Method of reporting gross premiums written

The proposed regulations provide that a non-life insurance company reports the full amount of gross premiums written for an insurance contract for the earlier of the taxable year which includes the effective date of the contract or the year in which all or a portion of the premium for the contract is received. A variety of comments were received with respect to the application of this timing rule to insurance contracts with installment premiums. In response to comments, the final regulations provide a number of exceptions from the general rule with respect to when an insurance company reports gross premiums written.

Advance premiums

Under the proposed regulations, a nonlife insurance company that receives a portion of the premium for an insurance contract prior to the effective date of the contract includes the full amount of the premium in gross premiums written for the taxable year during which the portion of the premium was received.

Several comments addressed the treatment of advance premiums in the proposed regulations. One comment endorsed the proposed treatment of advance premiums, noting that it is proper under statutory accounting principles to record the full amount of gross premiums written and expenses incurred with respect to a

casualty insurance policy for the year in which an advance premium is received. ²

Other comments argued that since the policyholder may demand a refund of an advance premium prior to the policy’s effective date, the company should be permitted to treat an advance premium as a nontaxable deposit until such time as coverage begins under the contract. Alternatively, these comments urged that the company be permitted to report only the advance premium (rather than the entire gross premium for the contract) in gross premiums written for the taxable year of receipt, and to report the remainder of the gross premium for the taxable year that includes the contract’s effective date. These comments also indicated that companies generally do not deduct the full amount of premium acquisition expenses for the contract in the taxable year in which they receive advance premiums.

In response to comments, the final regulations permit an insurance company that receives part of the gross premium for an insurance contract prior to the effective date of the contract to report only the advance premium (rather than the full amount of the gross premium written for the contract) in gross premiums written for the taxable year of receipt. The remainder of the gross premium for the insurance contract is included in gross premiums written for the taxable year which includes the effective date of the contract. This method of reporting gross premiums written is available only if the company’s deduction for premium acquisition expenses attributable to the contract does not exceed a limitation specified in the regulations, which is intended to ensure that a company does not deduct premium acquisition expenses attributable to an insurance contract more rapidly than the company includes premiums for the insurance contract in its gross premiums written. Companies that adopt this method of reporting gross pre-

2Prior to 1989, advance premiums were required to be reported in written premiums and unearned premiums on a non-life insurance company’s annual statement. However, statutory accounting principles were later modified to permit advance premiums to be accumulated in a suspense account and reported as a write-in liability on the annual statement. A company electing to use this alternative treatment would not report advance premiums in either written premiums or unearned premiums on its annual statement until the effective date of the underlying coverage.

January 24, 2000 366 2000–4 I.R.B.

miums written must use this method for all insurance contracts with advance premiums.

Accident and health insurance contracts

The proposed regulations have no special rules for determining gross premiums written with respect to accident and health insurance contracts. Several comments indicated that the longstanding practice of insurance companies that issue accident and health insurance contracts with installment premiums is to include amounts in gross premiums written for the taxable year in which the installment premiums become due under the contracts. These comments also stated that companies generally do not deduct premium acquisition expenses allocable to installment premiums not yet due or received with respect to accident and health insurance contracts.

In response to comments, the final regulations permit a non- life insurance company that either issues or proportionally reinsures cancellable accident and health insurance contracts with installment premiums to report the installment premiums in gross premiums written for the earlier of the taxable year in which the installment premiums become due under the terms of the contract or the taxable year in which the installment premiums are received. This method of reporting gross premiums written for cancellable accident and health insurance contracts with installment premiums is available only if the company’s deduction for premium acquisition expenses attributable to those contracts does not exceed the matching limitation specified in the regulations. Companies that adopt this method of reporting gross premiums written must use it for all cancellable accident and health insurance contracts with installment premiums.

Multi-year contracts with installment premiums

The final regulations also provide an exception with respect to the reporting of gross premiums written for a multiyear insurance contract for which the gross premium is payable in installments over the effective period of the contract. Under the final regulations, a company may treat this type of multi

year insurance contract as a series of separate insurance contracts. The first insurance contract in the series will be treated as having an effective period of 12 months. Subsequent insurance contracts in the series will be treated as having an effective period equal to the lesser of 12 months or the remainder of the period for which the rates for insurance coverage are guaranteed in the multi-year insurance contract.

This method of reporting gross premium written for a multi-year insurance contract with installment premiums is available only if the company’s deduction for premium acquisition expenses attributable to the contract does not exceed the matching limitation specified in the regulations. Companies that adopt this method of reporting gross premiums written for a multi-year insurance contract must use it for all multi-year contracts with installment premiums.

Contracts that give rise to life insurance reserves

Some insurance companies that are taxable under Part II of Subchapter L issue or reinsure risks relating to guaranteed renewable accident and health insurance contracts or other contracts that give rise to “life insurance reserves” (as defined in section 816(b)). For these companies, section 832(b)(4) provides that unearned premiums includes the amount of the company’s life insurance reserves, as determined under section 807. However, under section 832(b)(7), the unearned premiums for contracts giving rise to life insurance reserves are not reduced by 20 percent. Instead, an amount of otherwise deductible expenses equal to a percentage of the net premiums for the contracts must be capitalized and amortized as specified policy acquisition expenses under section 848. ³ For purposes of determining the amount of specified policy acquisition expenses under section 848, a non-life insurance company computes net premiums for the contracts in accordance with section 811(a). See section 848(d)(2). Thus, with respect to contracts described in section 832(b)(7), a non-life insurance company does not take into account unpaid premiums attributable to insurance cover

3Under section 848(e)(5), a contract that reinsures a contract subject to section 848 is treated in the same manner as the reinsured contract.

age not yet provided (such as deferred and uncollected premium installments) in determining the amount of specified policy acquisition expenses required to be amortized under section 848. The proposed regulations do not provide special rules for determining gross premiums written with respect to contracts described in section 832(b)(7). Under the final regulations, a non-life insurance company that issues or reinsures the risks related to a contract described in section 832(b)(7) may report gross premiums written for the contract in the manner required for life insurance companies under sections 803 and 811. This method of reporting gross premiums written for contracts described in section 832(b)(7) is available only if the company also determines its deduction for premium acquisition expenses for the contracts in accordance with section 811(a), as adjusted by the amount required to be amortized under section 848 based on the net premiums of the contracts. Thus, the final regulations ensure that the rules for determining premium income and amortizing premium acquisition expenses for contracts described in section 832(b)(7) operate consistently, whether the issuing company is a non-life insurance company or a life insurance company.

Fluctuating risk contracts

The method of reporting gross premiums written for certain insurance contracts covering fluctuating risks is reserved in the proposed regulations. Some comments requested that the final regulations not address the method of reporting gross premiums written for insurance contracts covering fluctuating risks, noting that the method of recording gross written premiums for these policies for annual statement reporting purposes was being considered by the NAIC as part of its project to codify statutory accounting principles. Subsequently, the NAIC issued guidance permitting an insurance company for annual statement purposes to report written premiums on workers’ compensation policies (but not on other casualty contracts involving “fluctuating risks,” such as commercial automobile liability and product liability policies) either on the effective date of the insurance contract or based on installment billings to the policyholder. By contrast, with re

2000–4 I.R.B. 367 January 24, 2000

spect to other types of casualty insurance policies, the NAIC reaffirmed the general rule that gross premiums with respect to these policies must be recorded on the annual statement on the effective date of the insurance contract.

The final regulations do not permit a non-life insurance company to report gross premiums written for a fluctuating risk contract based on installment billings to the policyholder. Rather, the final regulations require a company generally to report the gross premiums written for the contract for the earlier of the taxable year which includes the effective date of the contract or the year in which all or a portion of the premium for the contract is received, with special rules for advance premiums, cancellable accident and health contracts, multi-year insurance contracts, and contracts described in section 832(b)(7). The company reports any additional premiums resulting from an increase in risk exposure in gross premiums written for the taxable year in which the change in risk exposure occurs. Unless the increase in risk exposure is of temporary duration, the company determines the additional premium resulting from a change in risk exposure based on the remainder of the effective period of the contract.

Return premiums

The proposed regulations define return premiums as amounts (other than policyholder dividends or claims and benefit payments) paid or credited to the policyholder in accordance with the terms of an insurance contract. Under the final regulations, return premiums are amounts previously included in an insurance company’s gross premiums written, which are refundable to the policyholder (or the ceding company with respect of a reinsurance agreement) if the amounts are fixed by the insurance contract and do not depend on the experience of the insurance company or the discretion of its management. This rule incorporates a specific definition of policyholder dividends.

The final regulations list a number of items which are included in return premiums, to the extent they have previously been included in gross premiums written. These items include: (1) amounts that are refundable due to policy cancellations or decreases in risk exposure during the ef

fective period of an insurance contract; (2) the unearned portion of unpaid premiums for an insurance contract that is canceled or for which there is a decrease in risk exposure during its effective period; and (3) amounts that are either refundable or that reflect the unearned portion of unpaid premiums for an insurance contract, arising from the redetermination of the premium due to correction of posting or other similar errors.

In addition, the final regulation provides timing rules for the deduction of return premiums. If a contract is canceled, the return premium arising from that cancellation is deducted in the taxable year in which the contract is canceled. If there is a reduction in risk exposure under an insurance contract that gives rise to a return premium, such return premium is deductible in the taxable year in which the reduction in risk exposure occurs.

Retrospectively rated insurance contracts

The proposed regulations provide that gross written premiums include an insurance company’s estimate of additional premiums (retro debits) to be received with regard to the expired portion of a retrospectively rated insurance or reinsurance contract. The proposed regulations also provide that return premiums include an insurance company’s estimate of amounts to be refunded to policyholders (retro credits) with regard to the expired portion of a retrospectively rated insurance or reinsurance contract. The proposed regulations, therefore, would modify the treatment of retro credits under §1.832–4(a)(3)(ii) of the existing regulations, which treat retro credits as unearned premiums. At the option of the taxpayer, however, the proposed regulations permit a company to continue to include gross retro credits (but not gross retro debits) in the amount of unearned premiums subject to the 20 percent reduction under section 832(b)(4)(B).

A variety of comments were received with respect to the treatment of retro debits and retro credits in the proposed regulations. Most comments approved of the proposed rule to modify the treatment of retro credits in §1.832–4(a)(3)(ii) and, instead, to permit retro credits to be accounted for as part of return premiums. Some comments contended, however, that

the method of netting retro debits and retro credits as an adjustment to unearned premiums was required under NAIC accounting rules, prior case law, and the Service’s published rulings interpreting §1.832–4(a)(3)(ii). These comments argued that the enactment of the 20 percent reduction rule in 1986 did not authorize the Service to change the items included in unearned premiums, including the historical treatment of retro debits and retro credits as part of unearned premiums. Other comments contended that retro debits (but not retro credits) should be discounted using the applicable discount factors for unpaid losses under section 846. These comments argued that there is a direct correlation between amounts reported by an insurance company as retro debits and the company’s related liabilities for unpaid losses and unpaid loss adjustment expenses. Therefore, the comments urged that, to achieve proper matching of these items, a non-life insurance company should be permitted either to report retro debits as a subtraction from unearned premiums or to discount the retro debits using the applicable discount factors under section 846 for the related line of business.

The treatment of retro debits and retro credits in the proposed regulations was premised on the assumptions that retrospectively rated arrangements could qualify as insurance contracts for tax purposes, and that all amounts payable under such arrangements could be considered to have been paid for insurance coverage. The final regulations provide that gross premiums are amounts paid for insurance coverage. Similarly, unearned premiums and return premiums only include amounts included in gross written premiums. The final regulations also provide that retro credits are not included in unearned premiums, and retro debits cannot be subtracted from unearned premiums. The final regulations do not permit amounts includable in gross premiums written to be discounted, regardless of when such amounts are paid to the insurance company.

The final regulations do not provide any inference as to whether some or all of a retrospective arrangement can qualify as an insurance contract, or as to whether or the extent to which amounts paid or payable to an insurance company with re

January 24, 2000 368 2000–4 I.R.B.

spect to a retrospective arrangement are for insurance coverage.

Premium stabilization reserves

Several comments asked for clarification of the treatment of premium stabilization reserves. ⁴ As noted below, the final regulations provide that retro credits are not unearned premiums for Federal income tax purposes. Thus, retro credits added to premium stabilization reserves are not unearned premiums for Federal income tax purposes. The final regulations also provide that amounts withdrawn from a premium stabilization reserve to pay premiums are included in gross premiums written for the taxable year in which these amounts are withdrawn from the stabilization reserve for that purpose.

Unearned premiums

The proposed regulations define unearned premiums as the portion of the gross premiums written that is attributable to future insurance coverage to be provided under an insurance or reinsurance contract. The final regulations generally retain the rules relating to unearned premiums. Consistent with the existing regulations under §1.801–4(a), the final regulations provide that an insurance company must exclude from unearned premiums amounts attributable to the net value of risks reinsured with, or retroceded to, another insurance company. The final regulations also provide that unearned premiums do not include a liability established by an insurance company on its annual statement to cover premium deficiencies.

The proposed regulations provide that an insurance company may consider the incidence or pattern of the insured risks in determining the portion of the gross premium written that is attributable to the unexpired portion of the insurance coverage. The final regulations clarify that, if the risk of loss under an insurance contract

4In Rev. Rul. 97–5, 1997–1 C.B. 136, the Service revoked Rev. Rul. 70–480, 1970–2 C.B. 142, which had held that amounts held by a non-life insurance company in a premium stabilization reserve funded by retro credits are not unearned premiums under section 832(b)(4). Rev. Rul. 97–5 reasoned that the assumption in Rev. Rul. 70–480 that stabilization reserves are part of the insurance company’s surplus was erroneous.

does not vary significantly over the effective period of the contract, the unearned premium attributable to the unexpired portion of the effective period of the contract is determined on a pro rata basis. However, if the risk of loss under an insurance contract varies significantly over the effective period of the contract, the insurance company may consider the pattern and incidence of the risk in determining the portion of gross premium which are attributable to the unexpired portion of the effective period of the contract, provided that the company maintains sufficient information to demonstrate that its method of computing unearned premiums accurately reflects the pattern and incidence of the risk for the insurance contract.

Effective date and transition rules

Under the proposed regulations, the new rules apply to the determination of premiums earned for insurance contracts issued or renewed during taxable years beginning after January 6, 2000. Several comments requested that the regulations permit an insurance company to adopt the new rules for determining premiums earned as a change in method of accounting deemed made with the Commissioners’ consent, with audit protection for prior years. These comments also urged that the insurance company be given the option of either implementing the change in method of accounting on a cut-off basis or spreading the section 481(a) adjustments resulting from the change over a number of years consistent with the Commissioner’s general administrative procedures when a taxpayer files a request to change a method of accounting under section 446(e).

In response to these comments, the final regulations permit taxpayers to change their method of accounting for determining premiums earned to comply with the final regulations under the automatic change in method of accounting provisions of Rev. Proc. 99–49, 1999–52 I.R.B. 725, subject to certain limitations. A taxpayer makes the automatic change in method of accounting on its Federal income tax return for the first taxable year beginning after December 31, 1999 . The scope limitations in section 4.02 of Rev. Proc. 99–49 do not apply to a taxpayer’s automatic change in method of accounting

pursuant to this regulation. The timely duplicate filing requirement in section 6.02 of Rev. Proc. 99–49 also does not apply to this change. If the taxpayer’s method of computing earned premiums was an issue under consideration (within the meaning of section 3.09 of Rev. Proc. 99–49) on January 5, 2000 , however, then the audit protection rule in section 7.01 of Rev. Proc. 99–49 does not apply to the taxpayer’s change in method of accounting.

Special Analyses

It has been determined that this Treasury Decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It 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 these regulations do not impose on small entities a collection of information requirement, 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) 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 Gary Geisler, Office of the Assistant Chief Counsel (Financial Institutions and Products), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.832–4 is amended as follows:

1. Paragraph (a)(3) is revised.
2. Paragraphs (a)(4) and (a)(5) are redesignated as paragraphs (a)(13) and (a)(14).

2000–4 I.R.B. 369 January 24, 2000

3. New paragraphs (a)(4) through (a)(12) are added. The additions and revisions read as follows: §1.832–4 Gross income.

(a) * * * (3) Premiums earned . The determination of premiums earned on insurance contracts during the taxable year begins with the insurance company’s gross premiums written on insurance contracts during the taxable year, reduced by return premiums and premiums paid for reinsurance. Subject to the exceptions in sections 832(b)(7), 832(b)(8), and 833(a)(3), this amount is increased by 80 percent of the unearned premiums on insurance contracts at the end of the preceding taxable year, and is decreased by 80 percent of the unearned premiums on insurance contracts at the end of the current taxable year.

(4) Gross premiums written —(i) In general . Gross premiums written are amounts payable for insurance coverage. The label placed on a payment in a contract does not determine whether an amount is a gross premium written. Gross premiums written do not include other items of income described in section 832(b)(1)(C) (for example, charges for providing loss adjustment or claims processing services under administrative services or cost-plus arrangements). Gross premiums written on an insurance contract include all amounts payable for the effective period of the insurance contract. To the extent that amounts paid or payable with respect to an arrangement are not gross premiums written, the insurance company may not treat amounts payable to customers under the applicable portion of such arrangements as losses incurred described in section 832(b)(5). (ii) Items included. Gross premiums written include—

(A) Any additional premiums resulting from increases in risk exposure during the effective` period of an insurance contract;

(B) Amounts subtracted from a premium stabilization reserve to pay for insurance coverage; and

(C) Consideration in respect of assuming insurance liabilities under insurance contracts not issued by the taxpayer (such as a payment or transfer of property in an assumption reinsurance transaction).

(5) Method of reporting gross premi- ums written —(i) In general . Except as otherwise provided under this paragraph (a)(5), an insurance company reports gross premiums written for the earlier of the taxable year that includes the effective date of the insurance contract or the year in which the company receives all or a portion of the gross premium for the insurance contract. The effective date of the insurance contract is the date on which the insurance coverage provided by the contract commences. The effective period of an insurance contract is the period over which one or more rates for insurance coverage are guaranteed in the contract. If a new rate for insurance coverage is guaranteed after the effective date of an insurance contract, the making of such a guarantee generally is treated as the issuance of a new insurance contract with an effective period equal to the duration of the new guaranteed rate for insurance coverage.

(ii) Special rule for additional premi- ums resulting from an increase in risk exposure . An insurance company reports additional premiums that result from an increase in risk exposure during the effective period of an insurance contract in gross premiums written for the taxable year in which the change in risk exposure occurs. Unless the increase in risk exposure is of temporary duration (for example, an increase in risk exposure under a workers’ compensation policy due to seasonal variations in the policyholder’s payroll), the company reports additional premiums resulting from an increase in risk exposure based on the remainder of the effective period of the insurance contract.

(iii) Exception for certain advance premiums . If an insurance company receives a portion of the gross premium for an insurance contract prior to the first day of the taxable year that includes the effective date of the contract, the company may report the advance premium (rather than the full amount of the gross premium for the contract) in gross premiums written for the taxable year in which the advance premium is received. An insurance company may adopt this method of reporting advance premiums only if the company’s deduction for premium acquisition expenses for the taxable year in which the company receives the advance

premium does not exceed the limitation of paragraph (a)(5)(vii) of this section. A company that reports an advance premium in gross premiums written under this paragraph (a)(5)(iii) takes into account the remainder of the gross premium written and premium acquisition expenses for the contract in the taxable year that includes the effective date of the contract. A company that adopts this method of reporting advance premiums must use the method for all contracts with advance premiums.

(iv) Exception for certain cancellable accident and health insurance contracts with installment premiums . If an insurance company issues or proportionally reinsures a cancellable accident and health insurance contract (other than a contract with an effective period that exceeds 12 months) for which the gross premium is payable in installments over the effective period of the contract, the company may report the installment premiums (rather than the total gross premium for the contract) in gross premiums written for the earlier of the taxable year in which the installment premiums are due under the terms of the contract or the year in which the installment premiums are received. An insurance company may adopt this method of reporting installment premiums for a cancellable accident and health insurance contract only if the company’s deduction for premium acquisition expenses for the first taxable year in which an installment premium is due or received under the contract does not exceed the limitation of paragraph (a)(5)(vii) of this section. A company that adopts this method of reporting installment premiums for a cancellable accident and health contract must use the method for all of its cancellable accident and health insurance contracts with installment premiums.

(v) Exception for certain multi-year in- surance contracts . If an insurance company issues or proportionally reinsures an insurance contract, other than a contract described in paragraph (a)(5)(vi) of this section, with an effective period that exceeds 12 months, for which the gross premium is payable in installments over the effective period of the contract, the company may treat the insurance coverage provided under the multi-year contract as a series of separate insurance contracts.

January 24, 2000 370 2000–4 I.R.B.

The first contract in the series is treated as having been written for an effective period of twelve months. Each subsequent contract in the series is treated as having been written for an effective period equal to the lesser of 12 months or the remainder of the period for which the rates for insurance coverage are guaranteed in the multi-year insurance contract. An insurance company may adopt this method of reporting premiums on a multi-year contract only if the company’s deduction for premium acquisition expenses for each year of the multi-year contract does not exceed the limitation of paragraph (a)(5)(vii) of this section. A company that adopts this method of reporting premiums for a multi-year contract must use the method for all multi-year contracts with installment premiums.

(vi) Exception for insurance contracts described in section 832(b)(7) . If an insurance company issues or reinsures the risks related to a contract described in section 832(b)(7), the company may report gross premiums written for the contract in the manner required by sections 803 and 811(a) for life insurance companies. An insurance company may adopt this method of reporting premiums on contracts described in section 832(b)(7) only if the company also determines the deduction for premium acquisition costs for the contract in accordance with section 811(a), as adjusted by the amount required to be taken into account under section 848 in connection with the net premiums of the contract. A company that adopts this method of reporting premiums for a contract described in section 832(b)(7) must use the method for all of its contracts described in that section.

(vii) Limitation on deduction of pre- mium acquisition expenses . An insurance company’s deduction for premium acquisition expenses (for example, commissions, state premium taxes, overhead reimbursements to agents or brokers, and other similar amounts) related to an insurance contract is within the limitation of this paragraph (a)(5)(vii) if–

(A) The ratio obtained by dividing the sum of the company’s deduction for premium acquisition expenses related to the insurance contract for the taxable year and previous taxable years by the total premium acquisition expenses attributable to the insurance contract; does not

exceed

(B) The ratio obtained by dividing the sum of the amounts included in gross premiums written with regard to the insurance contract for the taxable year and previous taxable years by the total gross premium written for the insurance contract.

(viii) Change in method of reporting gross premiums. An insurance company that adopts a method of accounting for gross premiums written and premium acquisition expenses described in paragraph (a)(5)(iii), (iv), (v), or (vi) of this section must continue to use the method to report gross premiums written and premium acquisition expenses unless the company obtains the consent of the Commissioner to change to a different method under section 446(e) and §1.446–1(e).

(6) Return premiums —(i) In general . An insurance company’s liability for return premiums includes amounts previously included in an insurance company’s gross premiums written, which are refundable to a policyholder or ceding company, provided that the amounts are fixed by the insurance contract and do not depend on the experience of the insurance company or the discretion of its management.

(ii) Items included . Return premiums include amounts–

(A) Which were previously paid and become refundable due to policy cancellations or decreases in risk exposure during the effective period of an insurance contract;

(B) Which reflect the unearned portion of unpaid premiums for an insurance contract that is canceled or for which there is a decrease in risk exposure during its effective period; or

(C) Which are either previously paid and refundable or which reflect the unearned portion of unpaid premiums for an insurance contract, arising from the redetermination of a premium due to correction of posting or other similar errors.

(7) Method of reporting return premi- ums . An insurance company reports the liability for a return premium resulting from the cancellation of an insurance contract for the taxable year in which the contract is canceled. An insurance company reports the liability for a return premium attributable to a reduction in risk exposure under an insurance contract for the tax

able year in which the reduction in risk exposure occurs.

(8) Unearned premiums —(i) In gen- eral . The unearned premium for a contract, other than a contract described in section 816(b)(1)(B), generally is the portion of the gross premium written that is attributable to future insurance coverage during the effective period of the insurance contract. However, unearned premiums held by an insurance company with regard to the net value of risks reinsured with other solvent companies (whether or not authorized to conduct business under state law) are subtracted from the company’s unearned premiums. Unearned premiums also do not include any additional liability established by the insurance company on its annual statement to cover premium deficiencies. Unearned premiums do not include an insurance company’s estimate of its liability for amounts to be paid or credited to a customer with regard to the expired portion of a retrospectively rated contract (retro credits). An insurance company’s estimate of additional amounts payable by its customers with regard to the expired portion of a retrospectively rated contract (retro debits) cannot be subtracted from unearned premiums.

(ii) Special rules for unearned premi- ums . For purposes of computing “premiums earned on insurance contracts during the taxable year” under section 832(b)(4), the amount of unearned premiums includes—

(A) Life insurance reserves (as defined in section 816(b), but computed in accordance with section 807(d) and sections 811(c) and (d)); (B) In the case of a mutual flood or fire insurance company described in section 832(b)(1)(D) (with respect to contracts described in that section), the amount of unabsorbed premium deposits that the company would be obligated to return to its policyholders at the close of the taxable year if all its insurance contracts were terminated at that time;

(C) In the case of an interinsurer or reciprocal underwriter that reports unearned premiums on its annual statement net of premium acquisition expenses, the unearned premiums on the company’s annual statement increased by the portion of premium acquisition expenses allocable to those unearned premiums; and

2000–4 I.R.B. 371 January 24, 2000

(D) In the case of a title insurance company, its discounted unearned premiums (computed in accordance with section 832(b)(8)).

(9) Method of determining unearned premiums . If the risk of loss under an insurance contract does not vary significantly over the effective period of the contract, the unearned premium attributable to the unexpired portion of the effective period of the contract is determined on a pro rata basis. If the risk of loss varies significantly over the effective period of the contract, the insurance company may consider the pattern and incidence of the risk in determining the portion of the gross premium that is attributable to the unexpired portion of the effective period of the contract. An insurance company that uses a method of computing unearned premiums other than the pro rata method must maintain sufficient information to demonstrate that its method of computing unearned premiums accurately reflects the pattern and incidence of the risk for the insurance contract.

(10) Examples . The provisions of paragraphs (a)(4) through (a)(9) of this section are illustrated by the following examples:

Example 1 . (i) IC is a non-life insurance company which, pursuant to section 843, files its returns on a calendar year basis. IC writes a casualty insurance contract that provides insurance coverage for a one-year period beginning on July 1, 2000 and ending on June 30, 2001. IC charges a $500 premium for the insurance contract, which may be paid either in full by the effective date of the contract or in quarterly installments over the contract’s one year term. The policyholder selects the installment payment option. As of December 31, 2000, IC collected $250 of installment premiums for the contract.

(ii) The effective period of the insurance contract begins on July 1, 2000 and ends on June 30, 2001. For the taxable year ending December 31, 2000, IC includes the $500 gross premium, based on the effective period of the contract, in gross premiums written under section 832(b)(4)(A). IC’s unearned premium with respect to the contract was $250 as of December 31, 2000. Pursuant to section 832(b)(4)(B), to determine its premiums earned, IC deducts $200 ($250 x .8) for the insurance contract at the end of the taxable year.

Example 2 . (i) The facts are the same as Exam- ple 1, except that the insurance contract has a stated term of 5 years. On each contract anniversary date, IC may adjust the rate charged for the insurance coverage for the succeeding 12 month period. The amount of the adjustment in the charge for insurance coverage is not substantially limited under the insurance contract.

(ii) Under paragraph (a)(5)(i) of this section, IC is required to report gross premiums written for the

insurance contract based on the effective period for the contract. The effective period of the insurance contract is the period for which a rate for insurance coverage is guaranteed in the contract. Although the insurance contract issued by IC has a stated term of 5 years, a rate for insurance coverage is guaranteed only for a period of 12 months beginning with the contract’s effective date and each anniversary date thereafter. Thus, for the taxable year ending December 31, 2000, IC includes the $500 gross premium for the 12 month period beginning with the contract’s effective date in gross premiums written. IC’s unearned premium with respect to the contract was $250 as of December 31, 2000. Pursuant to section 832(b)(4)(B), to determine its premiums earned, IC deducts $200 ($250 x .8) for the insurance contract at the end of the taxable year.

Example 3 . (i) The facts are the same as Exam- ple 1, except that coverage under the insurance contract begins on January 1, 2001 and ends on December 31, 2001. On December 15, 2000, IC collects the first $125 premium installment on the insurance contract. For the taxable year ended December 31, 2000, IC deducts $20 of premium acquisition expenses related to the insurance contract. IC’s total premium acquisition expenses, based on the insurance contract’s $500 gross premium, are $80.

(ii) Under paragraph (a)(5)(iii) of this section, IC may elect to report only the $125 advance premium (rather than the contract’s $500 gross premium) in gross premiums written for the taxable year ended December 31, 2000, provided that IC’s deduction for the premium acquisition expenses related to the insurance contract does not exceed the limitation in paragraph (a)(5)(vii). IC’s deduction for premium acquisition expenses is within this limitation only if the ratio of the insurance contract’s premium acquisition expenses deducted for the taxable year and any previous taxable year to the insurance contract’s total premium acquisition expenses does not exceed the ratio of the amounts included in gross premiums written for the taxable year and any previous taxable year for the contract to the total gross premium written for the contract.

(iii) For the taxable year ended December 31, 2000, IC deducts $20 of premium acquisition expenses related to the insurance contract. This deduction represents 25% of the total premium acquisition expenses for the insurance contract ($20/$80 = 25%). This ratio does not exceed the ratio of the $125 advance premium to the insurance contract’s $500 gross premium ($125/$500 = 25%). Therefore, under paragraph (a)(5)(iii) of this section, IC may elect to report only the $125 advance premium (rather than the $500 gross premium) in gross premiums written for the taxable year ending December 31, 2000. IC reports the balance of the gross premium for the insurance contract ($375) and deducts the remaining premium acquisition expenses ($60) for the insurance contract in the taxable year ending December 31, 2001.

Example 4 . (i) The facts are the same as Exam- ple 3, except that for the taxable year ending December 31, 2000, IC deducts $60 of premium acquisition expenses related to the insurance contract.

(ii) For the taxable year ended December 31, 2000, IC deducted 75% of total premium acquisition expenses for the insurance contract ($60/$80 = 75%). This ratio exceeds the ratio of the $125 advance premium to the $500 gross premium

($125/$500 = 25%). Because IC’s deduction for premium acquisition expenses allocable to the contract exceeds the limitation in paragraph (a)(5)(vii) of this section, paragraph (a)(5)(i) of this section requires IC to report the $500 gross premium in gross premiums written for the taxable year ending December 31, 2000. IC’s unearned premium with respect to the contract was $500 as of December 31, 2000. Pursuant to section 832(b)(4)(B), to determine its premiums earned, IC deducts $400 ($500 x .8) for the insurance contract at the end of the taxable year.

Example 5 . (i) IC is a non-life insurance company which, pursuant to section 843, files its returns on a calendar year basis. On August 1, 2000, IC issues a one-year cancellable accident and health insurance policy to X, a corporation with 80 covered employees. The gross premium written for the insurance contract is $320,000. Premiums are payable in monthly installments. As of December 31, 2000, IC has collected $150,000 of installment premiums from X. For the taxable year ended December 31, 2000, IC has paid or incurred $21,000 of premium acquisition expenses related to the insurance contract. IC’s total premium acquisition expenses for the insurance contract, based on the $320,000 gross premium, are $48,000.

(ii) Under paragraph (a)(5)(iv) of this section, IC may elect to report only the $150,000 of installment premiums (rather than the $320,000 estimated gross premium) in gross premiums written for the taxable year ended December 31, 2000, provided that its deduction for premium acquisition expenses allocable to the insurance contract does not exceed the limitation in paragraph (a)(5)(vii). For the taxable year ended December 31, 2000, IC deducts $21,000 of premium acquisition expenses related to the insurance contract, or 43.75% of total premium acquisition expenses for the insurance contract ($21,000/$48,000 = 43.75%). This ratio does not exceed the ratio of installment premiums to the gross premium for the contract ($150,000/$320,000 = 46.9%). Therefore, under paragraph (a)(5)(iv) of this section, IC may elect to report only $150,000 of installment premiums for the insurance contract (rather than $320,000 of gross premium) in gross premiums written for the taxable year ending December 31, 2000.

Example 6 . (i) IC is a non-life insurance company which, pursuant to section 843, files its returns on a calendar year basis. On July 1, 2000, IC issues a one-year workers’ compensation policy to X, an employer. The gross premium for the policy is determined by applying a monthly rate of $25 to each of X’s employees. This rate is guaranteed for a period of 12 months, beginning with the effective date of the contract. On July 1, 2000, X has 1,050 employees. Based on the assumption that X’s payroll would remain constant during the effective period of the contract, IC determines an estimated gross premium for the contract of $315,000 (1,050 x $25 x 12 = $315,000). The estimated gross premium is payable by X in equal monthly installments. At the end of each calendar quarter, the premiums payable under the contract are adjusted based on an audit of X’s actual payroll during the preceding three months of coverage.

(ii) Due to an expansion of X’s business in 2000, the actual number of employees covered under the contract during each month of the period between

January 24, 2000 372 2000–4 I.R.B.

July 1, 2000 and December 31, 2000 is 1,050 (July), 1,050 (August), 1,050 (September), 1,200 (October), 1,200 (November), and 1,200 (December). The increase in the number of employees during the year is not attributable to a temporary or seasonal variation in X’s business activities and is expected to continue for the remainder of the effective period of the contract.

(iii) Under paragraph(a)(5)(i) of this section, IC is required to report gross premiums written for the insurance contract based the effective period of the contract. The effective period of X’s contract is based on the 12 month period for which IC has guaranteed rates for insurance coverage. Under paragraph (a)(5)(ii), IC must also report the additional premiums resulting from the change in risk exposure under the contract for the taxable year in which the change in such exposure occurs. Unless the change in risk exposure is of temporary duration, the additional gross premiums are included in gross premiums written for the remainder of the effective period of the contract. Thus, for the taxable year ending December 31, 2000, IC reports gross premiums written of $348,750 with respect to the workers’ compensation contract issued to X, consisting of the sum of the initial gross premium for the contract ($315,000) plus the additional gross premium attributable to the 150 employees added to X’s payroll who will be covered during the last nine months of the contract’s effective period (150 x $25 (monthly premium) x 9 = $33,750). IC’s unearned premium with respect to the contract was $180,000 as of December 31, 2000, which consists of the sum of the remaining portion of the original gross premium ($315,000 x 6/12 = $157,500), plus the additional premiums resulting from the change in risk exposure ($33,750 x 6/9 = $22,500) that are allocable to the remaining six months of the contract’s effective period. Pursuant to section 832(b)(4)(B), to determine its premiums earned, IC deducts $144,000 ($180,000 x .8) for the insurance contract at the end of the taxable year.

Example 7 . (i) The facts are the same as Exam- ple 6, except that the increase in the number of X’s employees for the period ending December 31, 2000 is attributable to a seasonal variation in X’s business activity.

(ii) Under paragraph (a)(5)(ii) of this section, for the taxable year ending December 31, 2000, IC reports gross premiums written of $326,500, consisting of the sum of the initial gross premium for the contract ($315,000) plus the additional premium attributable to the temporary increase in risk exposure during the taxable year (150 x $25 x 3 = $11,250). The unearned premium that is allocable to the remaining six months of the effective period of the contract is $157,500. Pursuant to section 832(b)(4)(B), to determine its premiums earned, IC deducts $126,000 ($157,500 x .8) for the insurance contract at the end of the taxable year.

Example 8 . (i) IC, a non-life insurance company, issues a noncancellable accident and health insurance contract (other than a qualified longterm care insurance contract, as defined in section 7702B(b)) to A, an individual, on July 1, 2000. The contract has an entry-age annual premium of $2,400, which is payable by A in equal monthly installments of $200 on the first day of each month of coverage. IC incurs agents’ commissions, pre

mium taxes, and other premium acquisition expenses equal to 10% of the gross premiums received for the contract. As of December 31, 2000, IC has collected $1,200 of installment premiums for the contract.

(ii) A noncancellable accident and health insurance contract is a contract described in section 832(b)(7). Thus, under paragraph (a)(5)(vi) of this section, IC may report gross premiums written in the manner required for life insurance companies under sections 803 and 811. Accordingly, for the taxable year ending December 31, 2000, IC may report gross premiums written of $1,200, based on the premiums actually received on the contract. Pursuant to section (a)(5)(vi) of this section, IC deducts a total of $28 of premium acquisition costs for the contract, based on the difference between the acquisition costs actually paid or incurred under section 811(a) ($1,200 x .10 = $120) and the amount required to taken into account under section 848 in connection with the net premiums for the contract ($1,200 x .077 = $92).

(iii) Under paragraph (a)(8)(ii)(A) of this section, IC includes the amount of life insurance reserves (as defined in section 816(b), but computed in accordance with section 807(d) and sections 811(c) and (d)) in unearned premiums under section 832(b)(4)(B). Section 807(d)(3)(A)(iii) requires IC to use a two-year preliminary term method to compute the amount of life insurance reserves for a noncancellable accident and health insurance contract (other than a qualified longterm care contract). Under this tax reserve method, no portion of the $1,200 gross premium received by IC for A’s contract is allocable to future insurance coverage. Accordingly, for the taxable year ending December 31, 2000, no life insurance reserves are included in IC’s unearned premiums under section 832(b)(4)(B) with respect to the contract.

Example 9 . (i) IC, a non-life insurance company, issues an insurance contract with a twelve month effective period for $1,200 on December 1, 2000. Immediately thereafter, IC reinsures 90% of its liability under the insurance contract for $900 with IC-2, an unrelated and solvent insurance company. On December 31, 2000, IC-2 has an $825 unearned premium with respect to the reinsurance contract it issued to IC. In computing its earned premiums, pursuant to section 832(b)(4)(B), IC-2 deducts $660 of unearned premiums ($825 x .8) with respect to the reinsurance contract.

(ii) Under paragraph (a)(8)(i) of this section, unearned premiums held by an insurance company with regard to the net value of the risks reinsured in other solvent companies are deducted from the ceding company’s unearned premiums taken into account for purposes of section 832(b)(4)(B). If IC had not reinsured 90% of its risks, IC’s unearned premium for the insurance contract would have been $1,100 ($1,200 x 11/12) and IC would have deducted $880 ($1,100 x .8) of unearned premiums with respect to such contract. However, because IC reinsured 90% of its risks under the contract with IC-2, as of December 31, 2000, the net value of the risks retained by IC for the remaining 11 months of the effective period of the contract is $110 ($1,100 - $990). For the taxable year ending December 31, 2000, IC includes the

$1,200 gross premium in its gross premiums written and deducts the $900 reinsurance premium paid to IC-2 under section 832(b)(4)(A). Pursuant to section 832(b)(4)(B), to determine its premiums earned, IC deducts $88 ($110 x .8) for the insurance contract at the end of the taxable year.

(11) Change in method of accounting —(i) In general . A change in the method of determining premiums earned to comply with the provisions of paragraphs (a)(3) through (a)(10) of this section is a change in method of accounting for which the consent of the Commissioner is required under section 446(e) and §1.446–1(e). (ii) Application . For the first taxable year beginning after December 31, 1999, a taxpayer is granted consent of the Commissioner to change its method of determining premiums earned to comply with the provisions of paragraphs (a)(3) through (a)(10) of this section. A taxpayer changing its method of accounting in accordance with this section must follow the automatic change in accounting provisions of Rev. Proc. 99–49, 1999–52 I.R.B. 725 (see §601.601(d)(2) of this chapter), except that–

(A) The scope limitations in section 4.02 of Rev. Proc. 99–49 shall not apply; (B) The timely duplicate filing requirement in section 6.02(2) of Rev. Proc. 99–49 shall not apply; and (C) If the method of accounting for determining premiums earned is an issue under consideration within the meaning of section 3.09 of Rev. Proc. 99–49 as of January 5, 2000, then section 7.01 of Rev. Proc. 99–49 shall not apply.

(12) Effective date . Paragraphs (a)(3) through (a)(11) of this section are applicable with respect to the determination of premiums earned for taxable years beginning after December 31, 1999.

• ---

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

Approved December 23, 1999.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 5, 2000, 8:45 a.m., and published in the issue of the Federal Register for January 6, 2000, 65 F.R. 701)

2000–4 I.R.B. 373 January 24, 2000

amount is determined by reference to actual retail sales by the carrier, the retail sales taken into account are sales of PTCs that provide the same type and amount of communications service. The final regulations also modify the markup percentage used when the face amount is determined by reference to the price at which the carrier sells the PTC to the transferee reseller. The proposed regulations apply a markup of 65 percent. Under the final regulations, the markup is reduced to 35 percent to correspond more closely to markups in the retail sector generally. Lastly, the final regulations modify the rule for determining the face amount by reference to the minutes of domestic communications service provided by the PTC. The proposed regulations provide that the face amount may be determined by multiplying the number of minutes by a flat $0.30 per-minute rate. As noted in the comments, however, a high-denomination PTC generally provides lower cost service on a per-minute basis than an otherwise equivalent low- denomination PTC. Accordingly, the final regulations provide that the per-minute rate used to determine face amount is reduced from $0.30 per minute to $0.20 per minute as the amount of domestic communications service provided by a PTC increases from 40 to 240 minutes.

For sales to transferee resellers, the final regulations do not permit carriers that can substantiate the actual retail price of a PTC to use that price as the face amount. The IRS and Treasury Department believe that the modifications to the methods for determining face amount address concerns that the prescribed methods may overstate the face amount. Moreover, a system based on the actual retail sale price when the retail sale is made by a person other than the carrier could prove very difficult for the IRS to administer because of the difficulty of verifying the prices at which PTCs are sold by large numbers of small retailers that may have acquired the PTCs indirectly through one or more transferee resellers.

Commenters also suggested that state and local taxes should be excluded from the face amount even if they are not separately stated. In general, the comments propose an exclusion based on the average amount of state and local taxes imposed on the carrier’s PTCs. These suggestions were not adopted. Section 4254(c) excludes from the section 4251 tax base only those state

Section 1441.—Withholding of Tax on Nonresident Aliens

26 CFR 1.1441–10: Recharacterizing financing arrangements involving fast-pay stock.

See T.D. 8853 on page 377

Section 4251.—Imposition of Tax

26 CFR 49.4251–4: Prepaid telephone cards.

T.D. 8855

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 49 and 602

Communications Excise Tax; Prepaid Telephone Cards

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the application of the communications excise tax to prepaid telephone cards (PTCs). The regulations implement certain changes made by the Taxpayer Relief Act of 1997. They affect certain telecommunications carriers, resellers, and purchasers of PTCs.

DATES: Effective Dates : These regulations are effective January 7, 2000.

Applicability Dates : For the date of applicability, see §49.4251–4(f).

FOR FURTHER INFORMATION CONTACT: Bernard H. Weberman (202) 6223130 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545-1628. Responses to this collection of information are required to obtain a tax benefit.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the col

lection of information displays a valid control number.

The estimated average burden per respondent is 0.25 hour. The estimated average annual burden per recordkeeper is 1.2 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 December 17, 1998, a notice of proposed rulemaking (REG–118620–97, 1999–9 I.R.B. 46) was published in the Fed- eral Register (63 FR 69585). Three written comments were received but no hearing was held because no requests to speak were received. The proposed regulations are adopted as revised by this Treasury decision.

The principal concerns of the commenters related to the rules for determining the face amount of an untariffed unit card transferred to a transferee reseller. The proposed regulations provide that the face amount can be determined by reference to actual retail sales by the carrier, by reference to the price at which the PTC is sold to the transferee reseller, or by reference to the minutes of domestic communications service provided by the PTC. One commenter requested additional explanation of the basis for these rules. Another suggested that in many situations, particularly in the case of high-denomination (for example, multihour) PTCs, none of the proposed methods for determining the face amount will accurately reflect the true retail value of the PTC. This commenter also suggested that if a carrier can substantiate the actual retail price of a PTC it should have the option of treating that price as the face amount.

The final regulations modify the rules relating to untariffed unit cards in three respects. First, they clarify that when the face

January 24, 2000 374 2000–4 I.R.B.

and local taxes that are imposed on the sale or furnishing of communications services and that are separately stated in the bill. A tax that is not separately stated (because, for example, it is imposed after the taxable sale of the PTC and its amount is not known at the time of the sale) does not qualify for this exclusion.

The regulations apply to PTCs transferred by carriers in calendar quarters beginning after January 7, 2000. Carriers and transferees may, however, rely on the regulations in determining the tax treatment of PTCs transferred in quarters beginning on or before that date.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It 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. It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that the time required to prepare or retain the notification is minimal and will not have a significant impact on those small entities that are required to provide notification. Furthermore, notification is provided only once to each seller. Accordingly, 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 Bernard H. Weberman, Office of Assistant Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

---

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 49 and 602 are amended as follows:

PART 49—FACILITIES AND SERVICES EXCISE TAXES

Paragraph 1. The authority citation for part 49 is revised to read as follows:

Authority: 26 U.S.C. 7805. Section 49.4251–4 also issued under 26 U.S.C. 4251(d).

Par. 2. Section 49.4251–4 is added to read as follows: §49.4251–4 Prepaid telephone cards.

(a) In general . In the case of communications services acquired by means of a prepaid telephone card (PTC), the face amount of the PTC is treated as an amount paid for communications services and that amount is treated as paid when the PTC is transferred by any carrier to any person that is not a carrier. This section provides rules for the application of the section 4251 tax to PTCs.

(b) Definitions . The following definitions apply to this section:

Carrier means a telecommunications carrier as defined in 47 U.S.C. 153.

Comparable PTC means a currently available dollar card or tariffed unit card (other than a PTC transferred in bulk or under special circumstances, such as for promotional purposes) that provides the same type and amount of communications services as the PTC to which it is being compared.

Dollar card means a PTC the value of which is designated by the carrier in dollars (even if also designated in units of service), provided that the designated value is not less than the amount for which the PTC is expected to be sold to a holder.

Holder means a person that purchases other than for resale.

Prepaid telephone card (PTC) means a card or similar arrangement that permits its holder to obtain a fixed amount of communications services by means of a code (such as a personal identification number (PIN)) or other access device provided by the carrier and to pay for those services in advance.

Tariff means a schedule of rates and regulations filed by a carrier with the Federal Communications Commission.

Tariffed unit card means a unit card that is transferred by a carrier—

(1) To a holder at a price that does not exceed the designated number of units on the PTC multiplied by the carrier’s tariffed price per unit; or

(2) To a transferee reseller subject to a contractual or other arrangement under which the price at which the PTC is sold to a holder will not exceed the designated number of units on the PTC multiplied by the carrier’s tariffed price per unit.

Transferee means the first person that is not a carrier to whom a PTC is transferred by a carrier.

Transferee reseller means a transferee that purchases a PTC for resale.

Unit card means a PTC other than a dollar card.

Untariffed unit card means a unit card other than a tariffed unit card.

(c) Determination of face amoun t—(1) Dollar card. The face amount of a dollar card is the designated dollar value.

(2) Tariffed unit card . The face amount of a tariffed unit card is the designated number of units on the PTC multiplied by the tariffed price per unit.

(3) Untariffed unit card —(i) Transfer to holder . The face amount of an untariffed unit card transferred by a carrier to a holder is the amount for which the carrier sells the PTC to the holder.

(ii) Transfer to transferee reseller —(A) In general . The face amount of an untariffed unit card transferred by a carrier to a transferee reseller is at the option of the carrier—

( 1 ) The highest amount for which the carrier sells a PTC that provides the same type and amount of communications services to a holder that ordinarily would not be expected to buy more than one such PTC at a time (if the carrier makes such sales on a regular and arm’s-length basis) or the face amount of a comparable PTC (if the carrier does not make such sales on a regular and arm’s-length basis);

( 2 ) 135 percent of the amount for which the carrier sells the PTC to the transferee reseller (including in that amount, in addition to any sum certain fixed at the time of the sale, any contingent amount per unit multiplied by the designated number of units on the PTC); or

( 3 ) If the PTC is of a type that ordinarily is used entirely for domestic communications service, the maximum number of minutes of domestic communications service on the PTC multiplied by the applicable rate.

(B) Applicable rate . The applicable rate under paragraph (c)(3)(ii)(A)( 3 ) of

2000–4 I.R.B. 375 January 24, 2000

this section with respect to a PTC is $0.30 reduced (but not below $0.20) by $0.01 for each full 20 minutes by which the maximum number of minutes of domestic communications service on the PTC exceeds 40 minutes.

(C) Sales not at arm’s length . In the case of a transfer of an untariffed unit card by a carrier to a transferee reseller otherwise than through an arm’s-length transaction, the fair market retail value of the PTC shall be substituted for the amount determined in paragraph (c)(3)(ii)(A)(2) of this section.

(4) Exclusion. The amount of any state or local tax imposed on the furnishing or sale of communications services that is separately stated in the bill or on the face of the PTC and the amount of any section 4251 tax separately stated in the bill or on the face of the PTC are disregarded in determining, for purposes of this paragraph (c), the amount for which a PTC is sold.

(d) Liability for tax —(1) In general. Under section 4251(d), the section 4251(a) tax is imposed on the transfer of a PTC by a carrier to a transferee. The person liable for the tax is the transferee. Except as provided in paragraph (d)(2) of this section, the person responsible for collecting the tax is the carrier transferring the PTC to the transferee. If a holder purchases a PTC from a transferee reseller, the amount the holder pays for the PTC is not treated as an amount paid for communications services and thus tax is not imposed on that payment.

(2) Effect of statement that purchaser is a carrier —(i) On transferor . A carrier that transfers a PTC to a purchaser is not responsible for collecting the tax if, at the time of transfer, the transferor carrier has received written notification from the purchaser that the purchaser is a carrier, and the transferor has no reason to believe otherwise. The notification to be provided by the purchaser is a statement, signed under penalties of perjury by a person with authority to bind the purchaser, that the purchaser is a carrier (as defined in paragraph (b) of this section). The statement is not required to take any particular form.

(ii) On purchaser . If a purchaser that is not a carrier provides the notification described in paragraph (d)(2)(i) of this section to the carrier that transfers a PTC, the purchaser remains liable for the tax imposed on the transfer of the PTC.

(3) Exemptions . Any exemptions available under section 4253 apply to the transfer of a PTC from a carrier to a holder. Section 4253 does not apply to the transfer of a PTC from a carrier to a transferee reseller.

(e) Examples. The following examples illustrate the provisions of this section:

Example 1. Unit card; sold to individual. (i) On May 1, 2000, A, a carrier, sells a card it calls a prepaid telephone card at A’s retail store to P, an individual, for P’s use in making telephone calls. A provides P with a PIN. The value of the card is not denominated in dollars, but the face of the card is marked 30 minutes. The sales price is $9. A tariff has not been filed for the minutes on the card. The toll telephone service acquired by purchasing the card will be obtained by entering the PIN and the telephone number to be called.

(ii) Because P purchased from a carrier other than for resale, P is a holder. The card provides its holder, P, with a fixed amount of communications services (30 minutes of toll telephone service) to be obtained by means of a PIN, for which P pays in advance of obtaining service; therefore, the card is a PTC. Because the value of the PTC is not designated in dollars and a tariff has not been filed for the minutes on the PTC, the PTC is an untariffed unit card. Because it is transferred by the carrier to the holder, the face amount is the sales price ($9).

(iii) The card is a PTC; thus, under section 4251(d), the face amount is treated as an amount paid for communications services and that amount is treated as paid when the PTC is transferred from A to P. Accordingly, at the time of transfer, P is liable for the 3 percent tax imposed by section 4251(a). The amount of the tax is $0.27 (3% x the $9 face amount). Thus, the total paid by P is $9.27, the $9 sales price plus $0.27 tax. A is responsible for collecting the tax from P.

Example 2. Unit card; given to individual . (i) The facts are the same as in Example 1, except that instead of selling a card, A gives a 30 minute card to P.

(ii) Although the card provides P with a fixed amount of communications services (30 minutes of toll telephone service) to be obtained by means of a PIN, P does not pay for the service. Therefore, the card is not a PTC, even though it is called a prepaid telephone card by A.

(iii) Because the card is not a PTC, section 4251(d) does not apply. Furthermore, no tax is imposed by section 4251(a) because no amount is paid for the communications services.

Example 3. Unit card; adding value. (i) After using the card described in Example 2, P arranges with A by telephone to have 30 minutes of toll telephone service added to the card. The sales price is $9. P is told to continue using the PIN provided with the card.

(ii) Because P purchased from a carrier other than for resale, P is a holder. The arrangement provides its holder, P, with a fixed amount of communications services (30 minutes of toll telephone service) to be obtained by means of a PIN, for which P pays in advance of obtaining service; therefore, the arrangement is a PTC. Because the value of the PTC is not designated in dollars and a tariff has not been filed for the minutes on the PTC, the PTC is an untariffed

Example 4. Dollar card; sold other than for re- sale . (i) On May 1, 2000, B, a carrier, sells 100,000 cards it calls prepaid telephone cards to Q, an auto dealer, for $50,000. Q will give away a card to each person that visits Q’s dealership. B provides Q with a PIN for each card. The face of each card is marked $3. The toll telephone service acquired by purchasing the card will be obtained by entering the PIN and the telephone number to be called.

(ii) Because Q purchased from a carrier other than for resale, Q is a holder. Each card provides its holder, Q, with a fixed amount of communications services ($3 of toll telephone service) to be obtained by means of a PIN, for which Q pays in advance of obtaining service; therefore, each card is a PTC even though Q’s visitors do not pay for the cards. The value of each PTC is designated in dollars; therefore, each PTC is a dollar card. Because the PTC is a dollar card, the face amount is the designated dollar value ($3).

(iii) The cards are PTCs; thus, under section 4251(d), the face amount is treated as an amount paid for communications services and that amount is treated as paid when the PTCs are transferred from B to Q. Accordingly, at the time of transfer, Q is liable for the 3 percent tax imposed by section 4251(a). The amount of the tax is $9,000 (3% x the $3 face amount x 100,000 PTCs). Thus, the total paid by Q is $59,000, the $50,000 sales price plus $9,000 tax. B is responsible for collecting the tax from Q.

Example 5. Tariffed unit card; sold to transferee reseller. (i) On May 1, 2000, C, a carrier, sells 1,000 cards it calls prepaid telephone cards to R, a convenience store owner, for $7,000. C provides R with a PIN for each card. The value of the cards is not denominated in dollars, but the face of each card is marked 30 minutes and a tariff of $0.33 per minute has been filed for the minutes on each card. R agrees that it will sell the cards to individuals for their own use and at a price that does not exceed $0.33 per minute. R actually sells the cards for $9 each (that is, at a price equivalent to $0.30 per minute). The toll telephone service acquired by purchasing the card will be obtained by entering the PIN and the telephone number to be called.

(ii) Because R purchased from a carrier for resale, R is a transferee reseller. Because R’s customers will purchase other than for resale, they will be holders. Each card sold by R provides its holder, R’s customer, with a fixed amount of communications services (30 minutes of toll telephone service) to be obtained by means of a PIN provided by the carrier, for which R’s customer pays in advance of obtaining service; therefore, each card is a PTC. Because the value of each PTC is not designated in dollars and C sells the PTCs to R subject to an arrangement under which the price at which the PTCs are sold to holders will not exceed the designated num

unit card. Because it is transferred by the carrier to the holder, the face amount is the sales price ($9).

(iii) The arrangement is a PTC; thus, under section 4251(d), the face amount is treated as an amount paid for communications services and that amount is treated as paid when the PTC is transferred from A to P. Accordingly, at the time of transfer, P is liable for the 3 percent tax imposed by section 4251(a). The amount of the tax is $0.27 (3% x the $9 face amount). Thus, the total paid by P is $9.27, the $9 sales price plus $0.27 tax. A is responsible for collecting the tax from P.

January 24, 2000 376 2000–4 I.R.B.

ber of minutes on the PTC multiplied by C’s tariffed price per minute, each PTC is a tariffed unit card. Because the PTCs are tariffed unit cards, the face amount of each PTC is $9.90, the designated number of minutes on the PTC multiplied by the tariffed price per minute (30 x $0.33), even though the retail sale price of each card is $9.

(iii) The cards are PTCs; thus, under section 4251(d), the face amount is treated as an amount paid for communications services and that amount is treated as paid when the PTC is transferred from C to R. Accordingly, at the time of transfer, R is liable for the 3 percent tax imposed by section 4251(a). The amount of the tax is $297 (3% x the $9.90 face amount x 1,000 PTCs). Thus, the total paid by R is $7,297, the $7,000 sales price plus $297 tax. C is responsible for collecting the tax from R.

Example 6. Unit card; sold to transferee reseller. (i) On May 1, 2000, D, a carrier, sells 10,000 cards it calls prepaid telephone cards to S, a convenience store owner, for $60,000. D provides S with a PIN for each card. The value of the cards is not denominated in dollars, but the face of each card is marked 30 minutes. A tariff has not been filed for the minutes on each card. S will sell the cards to individuals for their own use for $9 each. D also sells a card that provides 30 minutes of the same type of communications service at its retail store for $9. The toll telephone service acquired by purchasing the card will be obtained by entering the PIN and the telephone number to be called.

(ii) Because S purchased from a carrier for resale, S is a transferee reseller. Because S’s customers will purchase other than for resale, they will be holders. Each card sold by S provides its holder, S’s customer, with a fixed amount of communications services (30 minutes of toll telephone service) to be obtained by means of a PIN provided by the carrier, for which S’s customer pays in advance of obtaining service; therefore, each card is a PTC. Because the value of each PTC is not designated in dollars and a tariff has not been filed for the minutes on the PTC, each PTC is an untariffed unit card.

(iii) The PTCs are untariffed unit cards transferred by the carrier to a transferee reseller. Thus,

the face amount is determined under paragraph (c)(3)(ii) of this section, which permits D to choose from three alternative methods. Under paragraph (c)(3)(ii)(A)(1) of this section, the face amount of each PTC would be $9, the highest amount for which D sells to holders purchasing a single PTC. Alternatively, under paragraph (c)(3)(ii)(A)(2) of this section, the face amount of each PTC would be $8.10, computed as follows: 135% x the $60,000 sales price â 10,000 PTCs. Finally, under paragraph (c)(3)(ii)(A)(3) of this section (assuming the PTCs are of a type that ordinarily is used entirely for domestic communications services), the face amount of each PTC would be $9 ($0.30 x 30 minutes).

(iv) The cards are PTCs; thus, under section 4251(d), the face amount is treated as an amount paid for communications services and that amount is treated as paid when the PTCs are transferred from D to S. Accordingly, at the time of transfer, S is liable for the 3 percent tax imposed by section 4251(a). Assuming that D chooses to determine the face amount as provided in paragraph (c)(3)(ii)(A)(2) of this section, the amount of the tax is $2,430 (3% x the $8.10 face amount x 10,000 PTCs). Thus, the total paid by S is $62,430, the $60,000 sales price plus $2,430 tax. D is responsible for collecting the tax from S.

Example 7. Transfer of card that is not a PTC . (i) On May 1, 2000, E, a carrier, provides a telephone card to T, an individual, for T’s use in making telephone calls. E provides T with a PIN. The card provides access to an unlimited amount of communications services. E charges T $0.25 per minute of service, and bills T monthly for services used. The communications services acquired by using the card will be obtained by entering the PIN and the telephone number to be called.

(ii) Although the communications services will be obtained by means of a PIN, T does not receive a fixed amount of communications services. Also, T cannot pay in advance since the amount of T’s payment obligation depends upon the number of minutes used. Therefore, the card is not a PTC.

(iii) Because the card is not a PTC, section 4251(d) does not apply. However, the 3 percent tax

imposed by section 4251(a) applies to the amounts paid by T to E for the communications services. Accordingly, at the time an amount is paid for communications services, T is liable for tax. E is responsible for collecting the tax from T.

(f) Effective date . This section is applicable with respect to PTCs transferred by a carrier on or after the first day of the first calendar quarter beginning after January 7, 2000.

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 (b) is amended by adding an entry in numerical order to the table to read as follows: §602.101 OMB Control numbers.

• ---

(b) * * *

John M. Dalrymple, Acting Deputy Commissioner

of Internal Revenue.

Approved December 13, 1999.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 6, 2000, 8:45 a.m., and published in the issue of the Federal Register for January 7, 2000, 65 F.R. 1056)

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

• ---

49.4251–4(d)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1628

• ---

Section 7701.—Definitions

26 CFR 1.7701(l)–3: Recharacterizing financing arrangements involving fast-pay stock.

T.D. 8853

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

Recharacterizing Financing Arrangements Involving Fast- pay Stock

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that recharacterize, for tax purposes, financing arrangements in

volving fast-pay stock. The regulations are necessary to prevent taxpayers from using fast-pay stock to achieve inappropriate tax avoidance. The regulations affect corporations that issue fast-pay stock, holders of fast-pay stock, and other shareholders that may claim tax benefits purported to result from arrangements involving fast-pay stock. DATES: Effective Date : February 27, 1997.

2000–4 I.R.B. 377 January 24, 2000

Applicability Dates: For dates of applicability, see sections 1.1441–10(e) and 1.7701(l)–3(g) of these regulations.

FOR FURTHER INFORMATION CONTACT: Jonathan Zelnik, (202) 622-3920 (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 of 1995 (44 U.S.C. 3507(d)) under control number 1545-1642. Responses to this collection of information are mandatory.

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 average annual burden hours per respondent/recordkeeper: 1 hour.

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 a 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 information are confidential, as required by 26 U.S.C. 6103.

Background

On February 27, 1997, the IRS issued Notice 97–21, 1997–1 C.B. 407, which relates to financing arrangements involving fast-pay stock. Among other things, the notice informed the public that the IRS and Treasury Department expected to issue regulations recharacterizing these arrangements to prevent tax avoidance. No comments were received in response to Notice 97–21.

On January 6, 1999, the IRS published in the Federal Register a notice of proposed rulemaking (REG–104072–97,

1999–11 I.R.B. 12 [64 F.R. 805]) providing rules for the recharacterization of certain fast-pay arrangements under section 7701(l) of the Internal Revenue Code. Because no one requested to speak at the public hearing, the hearing was canceled. Four written comments responding to the notice of proposed rulemaking were received. The comments addressed neither (1) the accuracy of the estimate of the collection of information burden nor (2) the accuracy of the IRS’s understanding that the total number of entities engaging in transactions affected by these regulations is not substantial and most are not small entities within the meaning of the Regulatory Flexibility Act (5 U.S.C. chapter 6). After considering the comments, the proposed regulations are adopted as final regulations with some changes.

The preamble to the proposed regulations (64 FR 805) provides a detailed discussion of fast-pay arrangements and the proposed regulations.

SUMMARY OF COMMENTS AND CHANGES

In General

Two commentators were generally favorable to the proposed regulations. One considered them a reasonable attempt to address abusive transactions. The other viewed them as consistent with section 7701(l), but preferred, as a matter of tax policy, a legislative solution. One of these commentators also recommended narrowing the scope of the proposed regulations, asserting they might penalize shareholders who do not benefit from the fast-pay arrangement. Significantly, neither of these commentators recommended that the final regulations adopt a different approach, such as the one taken in Notice 97–21.

A third commentator criticized the proposed regulations as inconsistent with section 7701(l). This commentator viewed them as addressing not a conduit financing issue, but a tax accounting issue, namely, that the amount of dividend income under tax principles can exceed the economic income from the stock. Additionally, this commentator believed that regulations under section 7701(l) cannot operate if there is no back-to-back structure or if the corporation subject to recharacterization holds bona fide assets such as third-party debt. Finally, the com

mentator questioned whether the grant of regulatory authority under section 7701(l) permits recharacterizing transactions subject to other, comprehensive statutory rules such as the rules governing the transactions of RICs and REITs.

The IRS and Treasury Department have concluded that section 7701(l) authorizes recharacterization of any multiple-party financing transaction, including a fast-pay arrangement. The IRS and Treasury Department have also concluded (as did the other two commentators) that recharacterizing a fast-pay arrangement as an arrangement directly between the fast-pay shareholders and the benefited shareholders is consistent with the legislative mandate of section 7701(l). Thus, the final regulations retain the approach of the proposed regulations while making some changes to address other comments.

Definition of Fast-pay Stock

Under the proposed regulations, stock is fast-pay stock if it is structured so that dividends (as defined in section 316) paid by the corporation with respect to the stock are economically (in whole or in part) a return of the holder’s investment (as opposed to only a return on the holder’s investment). To determine if it is fast-pay stock, stock is examined when issued, and, for stock that is not fast-pay stock when issued, when there is a significant modification in the terms of the stock or the related agreements or a significant change in the relevant facts and circumstances.

Two commentators expressed concern about the interaction of section 302 with the definition of fast-pay stock and the duty to retest stock. In particular, the commentators asked whether stock that is not fast-pay stock when issued can become fast-pay stock solely because a redemption of the stock is treated as a dividend under section 302. This conversion is possible because section 302 treats certain redemptions as distributions of property to which section 301 applies rather than as distributions in exchange for stock.

The commentators gave different reasons why stock should not become fastpay stock solely because a redemption is treated as a dividend. One reason was that section 302 and the provisions referring to it (for example, section 1059(e)) already recharacterize certain redemp

January 24, 2000 378 2000–4 I.R.B.

tions of stock, which indicates Congress has determined the appropriate tax treatment of these transactions. Another reason was that applying the fast-pay regulations to arrangements involving redemptions may have a chilling effect on common, non-abusive transactions. Finally, it was suggested that any changes affecting the application of section 302 should be accomplished by issuing new regulations under that statute.

The IRS and Treasury Department agree it is inappropriate to treat as a fastpay arrangement every arrangement in which a redemption of stock produces dividend income under section 302. The IRS and Treasury Department, however, conclude that eliminating all such arrangements from the scope of the regulations would render the regulations meaningless. Little difference exists between a fast-pay arrangement resulting from redemptions structured to be dividends and a fast-pay arrangement resulting from dividends structured to be a return of the holder’s investment.

To balance the concerns of the commentators and the concerns of the IRS and Treasury Department, the final regulations add a new rule clarifying the effect of section 302 on the determination of whether stock is fast-pay stock. Under this rule, stock is not fast-pay stock solely because a redemption is treated as a dividend by section 302 unless there is a principal purpose of achieving the same economic and tax effect as a fast-pay arrangement. In this way, only those arrangements in which redemptions are designed to return a shareholder’s economic investment as dividends are recharacterized. Because the problem of stock redemptions may be common to many different fast-pay arrangements, regardless of how they are structured, the rule addressing such problem is placed within the regulations under section 7701(l) rather than under a different section.

Characterization of the Financing Instruments

Under the proposed regulations, the fast-pay shareholders are treated as holding financing instruments issued by the benefited shareholders rather than as holding the fast-pay stock. The character of financing instruments (for example, stock or debt) is determined under general

tax principles and depends on all the facts and circumstances.

All three commentators were concerned by the failure of the proposed regulations to classify the financing instruments as debt. If the financing instruments are classified as stock, the benefited shareholders are subject to substantially greater tax liabilities: they must include in income all dividends paid by the corporation that issues the fast-pay stock, but cannot deduct amounts deemed paid with respect to the financing instruments. According to the commentators, this result distorts the benefited shareholders’ economic income. Therefore, the regulations should classify the financing instruments as debt in all cases.

After careful consideration of the comments, the IRS and Treasury Department have decided against characterizing the financing instruments in the final regulations. Although debt characterization may be appropriate in some cases, in other cases it will be more appropriate to characterize the financing instruments as equity or something else. Thus, the rule in the proposed regulations is retained. (As explained below, however, the final regulations permit taxpayers, for a limited period, to determine their taxable income attributable to a recharacterized fast-pay arrangement by treating the financing instruments as debt.)

Election to Limit Taxable Income Attributable to a Recharacterized Fast- pay Arrangement for Periods Before April 1, 2000

Because the regulations are effective February 27, 1997 (the date Notice 97–21 was issued to the public), the proposed regulations permit a shareholder of a recharacterized fast-pay arrangement to limit, for certain taxable years, its income from the arrangement. Specifically, a shareholder may limit its taxable income attributable to a recharacterized fast-pay arrangement to the taxable income that results if the fast-pay arrangement is recharacterized under Notice 97–21. This limit is available under the proposed regulations for taxable years ending after the effective date of the regulations and before the regulations are finalized. Any amount excluded under this limit must be included as an adjustment to taxable income in the

shareholder’s first taxable year that includes the date the regulations are finalized. Thus, the sole benefit of limiting taxable income under the proposed regulations is a timing benefit. The preamble to the proposed regulations found this appropriate on the assumption that over the life of a fast-pay arrangement a shareholder has the same amount of taxable income whether the fast-pay arrangement is recharacterized under Notice 97–21 or under the regulations.

One commentator criticized this assumption, and, therefore, the limit and later adjustment. In particular, the commentator pointed out that if the financing instruments are treated as equity under the regulations, a benefited shareholder would have had less taxable income over the life of the fast-pay arrangement under the recharacterization of Notice 97–21 (that is, a shareholder would have a permanent reduction to taxable income). Thus, the limit is without any substantive effect because any non-timing reduction in taxable income due to the limit is included in the year the regulations are finalized. To rectify this problem, the commentator asked that, if the final regulations do not classify the financing instruments as debt in all cases, they should at least classify the financing instruments as debt for the period starting after the effective date of the final regulations and ending before the final regulations are published.

To address these concerns, the final regulations adopt a different rule from the one in the proposed regulations. As with the proposed regulations, a shareholder may limit its taxable income to either the amount determined under Notice 97–21 or the amount determined under the regulations. For purposes of this limit, a shareholder may assume the financing instruments are debt under the final regulations. A shareholder may also make this assumption to determine the amount of any later adjustment to income because of the limit. Thus, the later adjustment will not include any permanent reduction to taxable income a shareholder realizes by limiting its taxable income to the amount determined under Notice 97–21.

The final regulations also adopt a longer period during which shareholders may limit their taxable income. Under the proposed regulation, a shareholder

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may limit its taxable income for taxable years ending after February 26, 1997, and before the date these regulations are published as final regulations in the Federal Register. The final regulations permit a shareholder to limit its taxable income for all periods before April 1, 2000. Thus, for all taxable years ending after February 26, 1997 and before April 1, 2000, and for that part of a shareholder’s taxable year before April 1, 2000, a shareholder may limit its taxable income attributable to the fast-pay arrangement.

In permitting shareholders to determine their taxable income under the regulations by assuming that the financing instruments are debt for periods before April 1, 2000, the IRS and Treasury Department intend no implication regarding the proper characterization of the financing instruments under general tax principles. Rather, the rule regarding the financing instruments is intended solely for the purpose of giving shareholders the benefit of the recharacterization described in Notice 97–21 for periods before April 1, 2000.

Use of Derivatives to Avoid the Regulations

One commentator recommended adding an explicit rule to prevent parties from using derivative contracts to create a fast-pay arrangement that escapes either the regulations or the effect of the recharacterization rules. To illustrate this point, the commentator posited a simplified transaction in which a corporation issues fast-pay stock to one tax-exempt entity and benefited stock to another tax-exempt entity. The tax-exempt entity holding the benefited stock enters into a prepaid forward contract with a taxable person. Under the prepaid forward contract, the taxable person must buy the benefited stock in the future for an amount substantially below its expected value. According to the commentator, unless the taxable person is treated as owning the benefited stock, the parties have created a fast-pay arrangement in which the recharacterization of the regulations fails to prevent tax avoidance. Without making a recommendation, the commentator offered a number of rules to correct this situation. (The commentator did not discuss whether the benefited holder would be subject to the “debt-financing” rules in section 514).

The IRS and Treasury Department have

concluded that there is no present need to modify the regulations to address this problem. First, the tax treatment of derivatives in general is outside of the scope of these regulations. Therefore, a rule specific to these regulations would only increase the complexity regarding the tax treatment of derivatives. Second, and more importantly, the IRS and Treasury Department have concluded that under existing law the party entitled to purchase the benefited stock under a prepaid forward contract such as the one described above is the owner of the benefited stock for federal income tax purposes. See Rev. Rul. 82–150, 1982–2 C.B. 110 (concluding that the holder of a deep-in-themoney option is the owner of the reference property). Finally, the regulations state they are to be interpreted in a manner consistent with preventing the avoidance of tax. Mechanically applying the regulations in a manner that does not prevent tax avoidance is clearly inconsistent with the purpose of the regulations and the Congressional mandate of section 7701(l).

Fast-pay Arrangement Defined

The proposed regulations define a fastpay arrangement as any arrangement in which a corporation has outstanding for any part of its taxable year two or more classes of stock, at least one of which is fast-pay stock. Some taxpayers assert that the regulations can be avoided by creating a fast-pay arrangement in which a corporation issues what is nominally a single class of shares, notwithstanding that some of the shares are subject to a related agreement. These taxpayers apparently rely on the formal meaning of “class” under state corporate law and ignore the direction in the proposed regulations to determine whether stock is fastpay stock based on all the facts and circumstances.

To remove any doubt that the regulations cover fast-pay arrangements no matter how contrived, the IRS and Treasury Department have simplified the definition of “fast-pay arrangement” in the final regulations. Under this definition, a fast-pay arrangement is any arrangement in which a corporation has fast-pay stock outstanding for any part of its taxable year. The regulations illustrate this point with an example.

Effective Date

These regulations apply to taxable years ending after February 26, 1997.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the understanding of the IRS and Treasury Department that the total number of fast-pay arrangements is fewer than 100, that the number of entities engaging in transactions affected by these regulations is not substantial and, of those entities, few or none are small entities within the meaning of the Regulatory Flexibility Act (5 U.S.C. chapter 6). Therefore, a Regulatory Flexibility Analysis 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 comments on its impact on small businesses.

Drafting Information

The principal authors of these regulations are Jonathan Zelnik and Marshall Feiring of the Office of the Assistant Chief Counsel (Financial Institutions & Products). However, other personnel from the IRS and Treasury Department participated in their development.

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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 is amended by adding an entry in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.7701(l)–3 also issued under 26 U.S.C. 7701(l). * * * Par. 2. Section 1.1441–10, is added to read as follows:

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stock. (A) Sale of benefited stock. (B) Transactions other than sales. (iv) Adjustment to basis for amounts accrued or paid in taxable years ending before February 27, 1997. (d) Prohibition against affirmative use of recharacterization by taxpayers. (e) Examples. (f) Reporting requirement. (1) Filing requirements. (i) In general. (ii) Controlled foreign corporation. (iii) Foreign personal holding company. (iv) Passive foreign investment company. (2) Statement. (g) Effective date. (1) In general. (2) Election to limit taxable income attributable to a recharacterized fast-pay arrangement for periods before April 1, 2000. (i) Limit. (ii) Adjustment and statement. (iii) Examples. (3) Rule to comply with this section. (4) Reporting requirements.

Par. 4. Section 1.7701(l)–3 is added to read as follows: §1.7701(l)–3 Recharacterizing financing arrangements involving fast-pay stock.

(a) Purpose and scope. This section is intended to prevent the avoidance of tax by persons participating in fast-pay arrangements (as defined in paragraph (b)(1) of this section) and should be interpreted in a manner consistent with this purpose. This section applies to all fastpay arrangements. Paragraph (c) of this section recharacterizes certain fast-pay arrangements to ensure the participants are taxed in a manner reflecting the economic substance of the arrangements. Paragraph (f) of this section imposes reporting requirements on certain participants.

(b) Definitions —(1) Fast-pay arrange- ment . A fast-pay arrangement is any arrangement in which a corporation has fast-pay stock outstanding for any part of its taxable year.

(2) Fast-pay stock —(i) Defined . Stock is fast-pay stock if it is structured so that dividends (as defined in section 316) paid by the corporation with respect to the stock are economically (in whole or in part) a return of the holder’s investment (as opposed to only a return on the

§1.1441–10 Withholding agents with re- spect to fast-pay arrangements.

(a) In general. A corporation that issues fast-pay stock in a fast-pay arrangement described in §1.7701(l)–3(b)(1) is a withholding agent with respect to payments made on the fast-pay stock and payments deemed made under the recharacterization rules of §1.7701(l)–3. Except as provided in this paragraph (a) or in paragraph (b) of this section, the withholding tax rules under section 1441 and section 1442 apply with respect to a fastpay arrangement described in §1.7701(l)–3(c)(1)(i) in accordance with the recharacterization rules provided in §1.7701(l)–3(c). In all cases, notwithstanding paragraph (b) of this section, if at any time the withholding agent knows or has reason to know that the Commissioner has exercised the discretion under either §1.7701(l)–3(c)(1)(ii) to apply the recharacterization rules of §1.7701(l)–3(c), or §1.7701(l)–3(d) to depart from the recharacterization rules of §1.7701(l)–3(c) for a taxpayer, the withholding agent must withhold on payments made (or deemed made) to that taxpayer in accordance with the characterization of the fast-pay arrangement imposed by the Commissioner under §1.7701(l)–3.

(b) Exception. If at any time the withholding agent knows or has reason to know that any taxpayer entered into a fast-pay arrangement with a principal purpose of applying the recharacterization rules of §1.7701(l)–3(c) to avoid tax under section 871(a) or section 881, then for each payment made or deemed made to such taxpayer under the arrangement, the withholding agent must withhold, under section 1441 or section 1442, the higher of—

(1) The amount of withholding that would apply to such payment determined under the form of the arrangement; or

(2) The amount of withholding that would apply to deemed payments determined under the recharacterization rules of §1.7701(l)–3(c).

(c) Liability . Any person required to deduct and withhold tax under this section is made liable for that tax by section 1461, and is also liable for applicable penalties and interest for failing to comply with section 1461.

(d) Examples . The following examples illustrate the rules of this section:

Example 1 . REIT W issues shares of fast-pay stock to foreign individual A, a resident of Country C. United States source dividends paid to residents of C are subject to a 30 percent withholding tax. W issues all shares of benefited stock to foreign individuals who are residents of Country D. D’s income tax convention with the United States reduces the United States withholding tax on dividends to 15 percent. Under §1.7701(l)–3(c), the dividends paid by W to A are deemed to be paid by W to the benefited shareholders. W has reason to know that A entered into the fast-pay arrangement with a principal purpose of using the recharacterization rules of §1.7701(l)–3(c) to reduce United States withholding tax. W must withhold at the 30 percent rate because the amount of withholding that applies to the payments determined under the form of the arrangement is higher than the amount of withholding that applies to the payments determined under §1.7701(l)–3(c).

Example 2 . The facts are the same as in Example 1 of this paragraph (d) except that W does not know, or have reason to know, that A entered into the arrangement with a principal purpose of using the recharacterization rules of §1.7701(l)–3(c) to reduce United States withholding tax. Further, the Commissioner has not exercised the discretion under §1.7701(l)–3(d) to depart from the recharacterization rules of §1.7701(l)–3(c). Accordingly, W must withhold tax at a 15 percent rate on the dividends deemed paid to the benefited shareholders.

(e) Effective date . This section applies to payments made (or deemed made) on or after January 6, 1999.

Par. 3. Section 1.7701(l)–0 is added to read as follows: §1.7701(l)–0 Table of contents.

This section lists captions that appear in §§1.7701(l)–1 and 1.7701(l)–3: §1.7701(l)–1 Conduit financing arrange- ments. §1.7701(l)–3 Recharacterizing financing arrangements involving fast-pay stock. (a) Purpose and scope. (b) Definitions. (1) Fast-pay arrangement. (2) Fast-pay stock. (i) Defined. (ii) Determination. (3) Benefited stock. (c) Recharacterization of certain fast-pay arrangements. (1) Scope. (2) Recharacterization. (i) Relationship between benefited shareholders and fast-pay shareholders. (ii) Relationship between benefited shareholders and corporation. (iii) Relationship between fast-pay shareholders and corporation. (3) Other rules. (i) Character of the financing instruments. (ii) Multiple types of benefited stock. (iii) Transactions affecting benefited

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holder’s investment). Unless clearly demonstrated otherwise, stock is presumed to be fast-pay stock if—

(A) It is structured to have a dividend rate that is reasonably expected to decline (as opposed to a dividend rate that is reasonably expected to fluctuate or remain constant); or

(B) It is issued for an amount that exceeds (by more than a de minimis amount, as determined under the principles of §1.1273–1(d)) the amount at which the holder can be compelled to dispose of the stock.

(ii) Determination . The determination of whether stock is fast-pay stock is based on all the facts and circumstances, including any related agreements such as options or forward contracts. A related agreement includes any direct or indirect agreement or understanding, oral or written, between the holder of the stock and the issuing corporation, or between the holder of the stock and one or more other shareholders in the corporation. To determine if it is fast-pay stock, stock is examined when issued, and, for stock that is not fast-pay stock when issued, when there is a significant modification in the terms of the stock or the related agreements or a significant change in the relevant facts and circumstances. Stock is not fast-pay stock solely because a redemption is treated as a dividend as a result of section 302(d) unless there is a principal purpose of achieving the same economic and tax effect as a fast-pay arrangement.

(3) Benefited stock . With respect to any fast-pay stock, all other stock in the corporation (including other fast-pay stock having any significantly different characteristics) is benefited stock.

(c) Recharacterization of certain fast- pay arrangements - (1) Scope . This paragraph (c) applies to any fast-pay arrangement—

(i) In which the corporation that has outstanding fast-pay stock is a regulated investment company (RIC) (as defined in section 851) or a real estate investment trust (REIT) (as defined in section 856); or

(ii) If the Commissioner determines that a principal purpose for the structure of the fast-pay arrangement is the avoidance of any tax imposed by the Internal Revenue Code. Application of this paragraph (c)(1)(ii) is at the Commissioner’s

discretion, and a determination under this paragraph (c)(1)(ii) applies to all parties to the fast-pay arrangement, including transferees.

(2) Recharacterization . A fast-pay arrangement described in paragraph (c)(1) of this section is recharacterized as an arrangement directly between the benefited shareholders and the fast-pay shareholders. The inception and resulting relationships of the recharacterized arrangement are deemed to be as follows:

(i) Relationship between benefited shareholders and fast-pay shareholders . The benefited shareholders issue financial instruments (the financing instruments) directly to the fast-pay shareholders in exchange for cash equal to the fair market value of the fast-pay stock at the time of issuance (taking into account any related agreements). The financing instruments have the same terms (other than issuer) as the fast-pay stock. Thus, for example, the timing and amount of the payments made with respect to the financing instruments always match the timing and amount of the distributions made with respect to the fast-pay stock.

(ii) Relationship between benefited shareholders and corporation . The benefited shareholders contribute to the corporation the cash they receive for issuing the financing instruments. Distributions made with respect to the fast-pay stock are distributions made by the corporation with respect to the benefited shareholders’ benefited stock.

(iii) Relationship between fast-pay shareholders and corporation . For purposes of determining the relationship between the fast-pay shareholders and the corporation, the fast-pay stock is ignored. The corporation is the paying agent of the benefited shareholders with respect to the financing instruments.

(3) Other rules —(i) Character of the fi- nancing instruments . The character of a financing instrument (for example, stock or debt) is determined under general tax principles and depends on all the facts and circumstances.

(ii) Multiple types of benefited stock . If any benefited stock has any significantly different characteristics from any other benefited stock, the recharacterization rules of this paragraph (c) apply among the different types of benefited stock as appropriate to match the economic sub

stance of the fast-pay arrangement.

(iii) Transactions affecting benefited stock —(A) Sale of benefited stock . If one person sells benefited stock to another—

( 1 ) In addition to any consideration actually paid and received for the benefited stock, the buyer is deemed to pay and the seller is deemed to receive the amount necessary to terminate the seller’s position in the financing instruments at fair market value; and

( 2 ) The buyer is deemed to issue financing instruments to the fast-pay shareholders in exchange for the amount necessary to terminate the seller’s position in the financing instruments.

(B) Transactions other than sales . Except for transactions subject to paragraph (c)(3)(iii)(A) of this section, in the case of any transaction affecting benefited stock, the parties to the transaction must make appropriate adjustments to properly take into account the fast-pay arrangement as characterized under paragraph (c)(2) of this section.

(iv) Adjustment to basis for amounts accrued or paid in taxable years ending before February 27, 1997 . In the case of a fast-pay arrangement involving amounts accrued or paid in taxable years ending before February 27, 1997, and recharacterized under this paragraph (c), a benefited shareholder must decrease its basis in any benefited stock (as determined under paragraph (c)(2)(ii) of this section) by the amount (if any) that—

(A) Its income attributable to the benefited stock (reduced by deductions attributable to the financing instruments) for taxable years ending before February 27, 1997, computed by recharacterizing the fast-pay arrangement under this paragraph (c) and by treating the financing instruments as debt; exceeds

(B) Its income attributable to such stock for taxable years ending before February 27, 1997, computed without applying the rules of this paragraph (c).

(d) Prohibition against affirmative use of recharacterization by taxpayers . A taxpayer may not use the rules of paragraph (c) of this section if a principal purpose for using such rules is the avoidance of any tax imposed by the Internal Revenue Code. Thus, with respect to such taxpayer, the Commissioner may depart from the rules of this section and recharacterize (for all purposes of the Internal Revenue

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Code) the fast-pay arrangement in accordance with its form or its economic substance. For example, if a foreign person acquires fast-pay stock in a REIT and a principal purpose for acquiring such stock is to reduce United States withholding taxes by applying the rules of paragraph (c) of this section, the Commissioner may, for purposes of determining the foreign person’s United States tax consequences (including withholding tax), depart from the rules of paragraph (c) of this section and treat the foreign person as holding fast-pay stock in the REIT.

(e) Examples . The following examples illustrate the rules of paragraph (c) of this section:

Example 1. Decline in dividend rate —(i) Facts . Corporation X issues 100 shares of A Stock and 100 shares of B Stock for $1,000 per share. By its terms, a share of B Stock is reasonably expected to pay a $110 dividend in years 1 through 10 and a $30 dividend each year thereafter. If X liquidates, the holder of a share of B Stock is entitled to a preference equal to the share’s issue price. Otherwise, the B Stock cannot be redeemed at either X’s or the shareholder’s option.

(ii) Analysis . When issued, the B Stock has a dividend rate that is reasonably expected to decline from an annual rate of 11 percent of its issue price to an annual rate of 3 percent of its issue price. Since the B Stock is structured to have a declining dividend rate, the B Stock is fast-pay stock, and the A Stock is benefited stock.

Example 2. Issued at a premium —(i) Facts . The facts are the same as in Example 1 of this paragraph (e) except that a share of B Stock is reasonably expected to pay an annual $110 dividend as long as it is outstanding, and Corporation X has the right to redeem the B Stock for $400 a share at the end of year 10. (ii) Analysis . The B Stock is structured so that the issue price of the B Stock ($1,000) exceeds (by more than a de minimis amount) the price at which the holder can be compelled to dispose of the stock ($400). Thus, the B Stock is fast-pay stock, and the A Stock is benefited stock.

Example 3. Planned section 302(d) redemptions —(i) Facts . Corporation L, a subchapter C corporation, issues 220 shares of common stock for $1,000 per share. No other stock is authorized, but L can issue warrants entitling the holder to acquire L common stock for $3,000 per share until such time as L adopts a plan of liquidation. L can adopt a plan of liquidation if approved by 90 percent of its shareholders. Half of L’s stock is purchased by Corporation M, and half by Organization N, which is tax exempt. At the time of purchase, M and N agree that for a period of ten years L will annually redeem (and N will tender) ten shares of stock in exchange for $12,100 and ten warrants. It is anticipated that, under sections 302 and 301, the annual payment to N will be a distribution of property that is a dividend.

(ii) Analysis . Considering all the facts and circumstances, including the agreement between M and N, L’s redemption of N’s stock is undertaken

with a principal purpose of achieving the same economic and tax effect as a fast-pay arrangement. Thus, N’s stock is fast-pay stock, M’s stock is benefited stock, and the parties have entered into a fastpay arrangement. Because L is neither a RIC nor a REIT, whether this fast-pay arrangement is recharacterized under paragraph (c) of this section depends on whether the Commissioner determines, under paragraph (c)(1)(ii) of this section, that a principal purpose for the structure of the fast-pay arrangement is the avoidance of any tax imposed by the Internal Revenue Code.

Example 4. Recharacterization illustrated —(i) Facts . On formation, REIT Y issues 100 shares of C Stock and 100 shares of D Stock for $1,000 per share. By its terms, a share of D Stock is reasonably expected to pay a $110 dividend in years 1 through 10 and a $30 dividend each year thereafter. In years 1 through 10, persons holding a majority of the D Stock must consent before Y may take any action that would result in Y liquidating or dissolving, merging or consolidating, losing its REIT status, or selling substantially all of its assets. Thereafter, Y may take these actions without consent so long as the D Stock shareholders receive $400 in exchange for their D Stock.

(ii) Analysis . When issued, the D Stock has a dividend rate that is reasonably expected to decline from an annual rate of 11 percent of its issue price to an annual rate of 3 percent of its issue price. In addition, the $1,000 issue price of a share of D Stock exceeds the price at which the shareholder can be compelled to dispose of the stock ($400). Thus, the D Stock is fast-pay stock, and the C Stock is benefited stock. Because Y is a REIT, the fast-pay arrangement is recharacterized under paragraph (c) of this section.

(iii) Recharacterization . The fast-pay arrangement is recharacterized as follows:

(A) Under paragraph (c)(2)(i) of this section, the C Stock shareholders are treated as issuing financing instruments to the D Stock shareholders in exchange for $100,000 ($1,000, the fair market value of each share of D Stock, multiplied by 100, the number of shares).

(B) Under paragraph (c)(2)(ii) of this section, the C Stock shareholders are treated as contributing $200,000 to Y (the $100,000 received for the financing instruments, plus the $100,000 actually paid for the C Stock) in exchange for the C Stock.

(C) Under paragraph (c)(2)(ii) of this section, each distribution with respect to the D Stock is treated as a distribution with respect to the C Stock.

(D) Under paragraph (c)(2)(iii) of this section, the C Stock shareholders are treated as making payments with respect to the financing instruments, and Y is treated as the paying agent of the financing instruments for the C Stock shareholders.

Example 5. Transfer of benefited stock illus- trated - (i) Facts . The facts are the same as in Ex- ample 4 of this paragraph (e). Near the end of year 5, a person holding one share of C Stock sells it for $1,300. The buyer is unrelated to REIT Y or to any of the D Stock shareholders. At the time of the sale, the amount needed to terminate the seller’s position in the financing instruments at fair market value is $747.

(ii) Benefited shareholder’s treatment on sale . Under paragraph (c)(3)(iii)(A) of this section, the seller’s amount realized is $2,047 ($1,300, the

amount actually received, plus $747, the amount necessary to terminate the seller’s position in the financing instruments at fair market value). The seller’s gain on the sale of the common stock is $47 ($2,047, the amount realized, minus $2,000, the seller’s basis in the common stock). The seller has no income or deduction with respect to terminating its position in the financing instruments.

(iii) Buyer’s treatment on purchase . Under paragraph (c)(3)(iii)(A) of this section, the buyer’s basis in the share of D Stock is $2,047 ($1,300, the amount actually paid, plus $747, the amount needed to terminate the seller’s position in the financing instruments at fair market value). Under paragraph (c)(3)(iii)(B) of this section, simultaneous with the sale, the buyer is treated as issuing financing instruments to the fast-pay shareholders in exchange for $747, the amount necessary to terminate the seller’s position in the financing instruments at fair market value.

Example 6. Fast-pay arrangement involving amounts accrued or paid in a taxable year ending before February 27, 1997 - (i) Facts . Y is a calendar year taxpayer. In June 1996, Y acquires shares of REIT T benefited stock for $15,000. In December 1996, Y receives dividends of $100. Under the recharacterization rules of paragraph (c)(2) of this section, Y’s 1996 income attributable to the benefited stock is $1,200, Y’s 1996 deduction attributable to the financing instruments is $500, and Y’s basis in the benefited stock is $25,000.

(ii) Analysis . Under paragraph (c)(3)(iv) of this section, Y’s basis in the benefited stock is reduced by $600. This is the amount by which Y’s 1996 income from the fast-pay arrangement as recharacterized under this section ($1,200 of income attributable to the benefited stock less $500 of deductions attributable to the financing instruments), exceeds Y’s 1996 income from the fast-pay arrangement as not recharacterized under this section ($100 of income attributable to the benefited stock). Thus, in 1997 when the fast-pay arrangement is recharacterized, Y’s basis in the benefited stock is $24,400.

(f) Reporting requirement —(1) Filing requirements —(i) In general . A corporation that has fast-pay stock outstanding at any time during the taxable year must attach the statement described in paragraph (f)(2) of this section to its federal income tax return for such taxable year. This paragraph (f)(1)(i) does not apply to a corporation described in paragraphs (f)(1)(ii), (iii), or (iv) of this section.

(ii) Controlled foreign corporation . In the case of a controlled foreign corporation (CFC), as defined in section 957, that has fast-pay stock outstanding at any time during its taxable year (during which time it was a CFC), each controlling United States shareholder (within the meaning of §1.964-1(c)(5)) must attach the statement described in paragraph (f)(2) of this section to the shareholder’s Form 5471 for the CFC’s taxable year. The provisions of section 6038 and the regulations under

2000–4 I.R.B. 383 January 24, 2000

section 6038 apply to any statement required by this paragraph (f)(1)(ii).

(iii) Foreign personal holding com- pany . In the case of a foreign personal holding company (FPHC), as defined in section 552, that has fast-pay stock outstanding at any time during its taxable year (during which time it was a FPHC), each United States citizen or resident who is an officer, director, or 10-percent shareholder (within the meaning of section 6035(e)(1)) of such FPHC must attach the statement described in paragraph (f)(2) of this section to his or her Form 5471 for the FPHC’s taxable year. The provisions of sections 6035 and 6679 and the regulations under sections 6035 and 6679 apply to any statement required by this paragraph (f)(1)(iii).

(iv) Passive foreign investment com- pany. In the case of a passive foreign investment company (PFIC), as defined in section 1297, that has fast-pay stock outstanding at any time during its taxable year (during which time it was a PFIC), each shareholder that has elected (under section 1295) to treat the PFIC as a qualified electing fund and knows or has reason to know that the PFIC has outstanding fast-pay stock must attach the statement described in paragraph (f)(2) of this section to the shareholder’s Form 8621 for the PFIC’s taxable year. Each shareholder owning 10 percent or more of the shares of the PFIC (by vote or value) is presumed to know that the PFIC has issued fast-pay stock. The provisions of sections 1295(a)(2) and 1298(f) and the regulations under those sections (including §1.1295–1T(f)(2)) apply to any statement required by this paragraph (f)(1)(iv).

(2) Statement . The statement required under this paragraph (f) must say, “This fast-pay stock disclosure statement is required by §1.7701(l)–3(f) of the income tax regulations.” The statement must also identify the corporation that has outstanding fast-pay stock and must contain the date on which the fast-pay stock was issued, the terms of the fast-pay stock, and (to the extent the filing person knows or has reason to know such information) the names and taxpayer identification numbers of the shareholders of any stock that is not traded on an established securities market (as described in §1.7704–1(b)).

(g) Effective date —(1) In general . Except as provided in paragraph (g)(4) of

this section (relating to reporting requirements), this section applies to taxable years ending after February 26, 1997. Thus, all amounts accrued or paid during the first taxable year ending after February 26, 1997, are subject to this section.

(2) Election to limit taxable income at- tributable to a recharacterized fast-pay arrangement for periods before April 1, 2000 —(i) Limit . For periods before April 1, 2000, provided the shareholder recharacterizes the fast-pay arrangement consistently for all such periods, a shareholder may limit its taxable income attributable to a fast-pay arrangement recharacterized under paragraph (c) of this section to the taxable income that results if the fast-pay arrangement is recharacterized under either—

(A) Notice 97–21, 1997–1 C.B. 407, see §601.601(d)(2) of this chapter; or

(B) Paragraph (c) of this section, computed by assuming the financing instruments are debt.

(ii) Adjustment and statement . A shareholder that limits its taxable income to the amount determined under paragraph (g)(2)(i)(A) of this section must include as an adjustment to taxable income the excess, if any, of the amount determined under paragraph (g)(2)(i)(B) of this section, over the amount determined under paragraph (g)(2)(i)(A) of this section. This adjustment to taxable income must be made in the shareholder’s first taxable year that includes April 1, 2000. A shareholder to which this paragraph (g)(2)(ii) applies must include a statement in its books and records identifying each fast-pay arrangement for which an adjustment must be made and providing the amount of the adjustment for each such fast-pay arrangement.

(iii) Examples . The following examples illustrate the rules of this paragraph (g)(2). For purposes of these examples, assume that a shareholder may limit its taxable income under this paragraph (g)(2) for periods before January 1, 2000. Example 1. Fast-pay arrangement recharacter- ized under Notice 97–21; REIT holds third-party debt —(i) Facts . (A) REIT Y is formed on January 1, 1997, at which time it issues 1,000 shares of fastpay stock and 1,000 shares of benefited stock for $100 per share. Y and all of its shareholders are U.S. persons and have calendar taxable years. All shareholders of Y have elected to accrue market discount based on a constant interest rate, to include the market discount in income as it accrues, and to

amortize bond premium.

(B) For years 1 through 5, the fast-pay stock has an annual dividend rate of $17 per share ($17,000 for all fast-pay stock); in later years, the fast-pay stock has an annual dividend rate of $1 per share ($1,000 for all fast-pay stock). At the end of year 5, and thereafter, a share of fast-pay stock can be acquired by Y in exchange for $50 ($50,000 for all fast-pay stock).

(C) On the day Y is formed, it acquires a fiveyear mortgage note (the note) issued by an unrelated third party for $200,000. The note provides for annual interest payments on December 31 of $18,000 (a coupon interest rate of 9.00 percent, compounded annually), and one payment of principal at the end of 5 years. The note can be prepaid, in whole or in part, at any time.

(ii) Recharacterization under Notice 97–21 —(A) In general . One way to recharacterize the fast-pay arrangement under Notice 97–21 is to treat the fastpay shareholders and the benefited shareholders as if they jointly purchased the note from the issuer with the understanding that over the five-year term of the note the benefited shareholders would use their share of the interest to buy (on a dollar-for-dollar basis) the fast-pay shareholders’ portion of the note. The benefited shareholders’ and the fast-pay shareholders’ yearly taxable income under Notice 97–21 can then be calculated after determining their initial portions of the note and whether those initial portions are purchased at a discount or premium.

(B) Determining initial portions of the debt in- strument . The fast-pay shareholders’ and the benefited shareholders’ initial portions of the note can be determined by comparing the present values of their expected cash flows. As a group, the fast-pay shareholders expect to receive cash flows of $135,000 (five annual payments of $17,000, plus a final payment of $50,000). As a group, the benefited shareholders expect to receive cash flows of $155,000 (five annual payments of $1,000, plus a final payment of $150,000). Using a discount rate equal to the yield to maturity (as determined under §1.1272–1(b)(1)(i)) of the mortgage note (9.00 percent, compounded annually), the present value of the fast-pay shareholders’ cash flows is $98,620, and the present value of the benefited shareholders’ cash flows is $101,380. Thus, the fast-pay shareholders initially acquire 49 percent of the note at a $1,380 premium (that is, they paid $100,000 for $98,620 of principal in the note). The benefited shareholders initially acquire 51 percent of the note at a $1,380 discount (that is, they paid $100,000 for $101,380 of principal in the note). Under section 171, the fastpay shareholders’ premium is amortizable based on their yield in their initial portion of the note (8.574 percent, compounded annually). The benefited shareholders’ discount accrues based on the yield in their initial portion of the note (9.353 percent, compounded annually).

(C) Taxable income under Notice 97–21 —(1) Fast-pay shareholders . Under Notice 97–21, the fast-pay shareholders compute their taxable income attributable to the fast-pay arrangement for periods before January 1, 2000, by subtracting the amortizable premium from the accrued interest on the fastpay shareholders’ portion of the note. For purposes of paragraph (g)(2)(i)(A) of this section, the fast-pay shareholders’ taxable income as a group is as follows:

January 24, 2000 384 2000–4 I.R.B.

Interest Amortizable Taxable Taxable Period Income Premium Income

1/1/97 - 12/31/97 $ 8,876 ($302) $ 8,574

1/1/98 - 12/31/98 $ 8,145 ($293) $ 7,852 1/1/99 - 12/31/99 $ 7,348 ($281) $ 7,067

$24,369 ($876) $23,493

( 2 ) Benefited shareholders . Under Notice 97–21, the benefited shareholders compute their taxable income attributable to the fast-pay

arrangement for periods before January 1, 2000, by adding the accrued discount to the accrued interest on the benefited shareholders’ portion of the

note. For purposes of paragraph (g)(2)(i)(A) of this section, the benefited shareholders’ taxable income as a group is as follows:

Interest Accrued Taxable Taxable Period Income Discount Income

1/1/97 - 12/31/97 $ 9,124 $229 $ 9,353

1/1/98 - 12/31/98 $ 9,855 $251 $10,106

1/1/99 - 12/31/99 $10,652 $274 $10,926

$29,631 $754 $30,385

(iii) Taxable income under the recharacteriza- tion of this section —(A) Fast-pay shareholders . Under paragraphs (c) and (g)(2)(i)(B) of this section, the fast-pay shareholders’ taxable income attributable to the fast-pay arrangement for periods before January 1, 2000, is the interest deemed paid on the financing instruments. For purposes of paragraph (g)(2)(i)(B) of this section, the fast-pay shareholders’ taxable income as a group is as follows:

Taxable

Taxable Period Income

1/1/97 - 12/31/97 $ 8,574

1/1/98 - 12/31/98 $ 7,852

1/1/99 - 12/31/99 $ 7,067

$23,493

(B) Benefited shareholders . Under paragraphs (c) and (g)(2)(i)(B) of this section, the benefited shareholders compute their taxable income attributable to the fast-pay arrangement for periods before January 1, 2000, by subtracting the interest deemed paid on the financing instruments from the dividends actually and deemed paid on the benefited stock. For purposes of paragraph (g)(2)(i)(B) of this section, the benefited shareholders’ taxable income as a group is as follows:

Dividends Interest Paid Paid On On Financing Taxable Taxable Period Benefited Stock Instruments Income

1/1/97 - 12/31/97 $18,000 ($ 8,574) $ 9,426

1/1/98 - 12/31/98 $18,000 ($ 7,852) $10,148

1/1/99 - 12/31/99 $18,000 ($ 7,067) $10,933

$54,000 ($23,493) $30,507

(iv) Limit on taxable income under paragraph (g)(2)(i) of this section —(A) Fast-pay sharehold- ers . For periods before January 1, 2000, the fastpay shareholders have the same taxable income under the recharacterization of Notice 97–21 and paragraph (g)(2)(i)(A) of this section ($23,493) as they have under the recharacterization of paragraphs (c) and (g)(2)(i)(B) of this section ($23,493). Thus, under paragraph (g)(2)(i) of this section, the fast-pay shareholders may limit their taxable income attributable to the fast-pay arrangement for periods before January 1, 2000, to $23,493 (as a group).

(B) Benefited shareholders . For periods before January 1, 2000, the benefited shareholders have taxable income attributable to the fast-pay arrangement of $30,385 under the recharacterization of Notice 97–21 and paragraph (g)(2)(i)(A) of this section, and taxable income of $30,507 under the recharacterization of paragraphs (c) and (g)(2)(i)(B) of this section. Thus, under paragraph (g)(2)(i) of this section, the benefited shareholders may limit their taxable income attributable to the fast-pay arrangement for periods before January 1, 2000, to either $30,385 (as a group) or $30,507 (as a group).

(v) Adjustment to taxable income under para-

graph (g)(2)(ii) of this section . Under paragraph (g)(2)(ii) of this section, any benefited shareholder that limited its taxable income to the amount determined under paragraph (g)(2)(i)(A) of this section must include as an adjustment to taxable income the excess, if any, of the amount determined under paragraph (g)(2)(i)(B) of this section, over the amount determined under paragraph (g)(2)(i)(A) of this section. If all benefited shareholders limited their taxable income to the amount determined under paragraph (g)(2)(i)(A) of this section, then as a group their adjustment to income is $122 ($30,507, minus $30,385). Each shareholder must include its adjustment in income for the taxable year that includes January 1, 2000.

Example 2. REIT holds debt issued by a bene- fited shareholder —(i) Facts . The facts are the same as in Example 1 of this paragraph (g)(2) except that corporation Z holds 800 shares (80 percent) of the benefited stock, and Z, instead of a third party, issues the mortgage note acquired by Y.

(ii) Recharacterization under Notice 97–21 . Because Y holds a debt instrument issued by Z, the fast-pay arrangement is recharacterized under Notice 97–21 as an arrangement in which Z issued one or more instruments directly to the fast-pay shareholders and the other benefited shareholders.

(A) Fast-pay shareholders . Consistent with this recharacterization, Z is treated as issuing a debt instrument to the fast-pay shareholders for $100,000. The debt instrument provides for five annual payments of $17,000 and an additional payment of $50,000 in year five. Thus, the debt instrument’s yield to maturity is 8.574 percent per annum, compounded annually.

(B) Benefited shareholders . Z is also treated as issuing a debt instrument to the other benefited shareholders for $20,000 (200 shares multiplied by $100, or 20 percent of the $100,000 paid to Y by the benefited shareholders as a group). This debt instrument provides for five annual payments of $200 and an additional payment of $30,000 in year five. The debt instrument’s yield to maturity is 9.304 percent per annum, compounded annually.

(C) Issuer’s interest expense under Notice 97–21 . Under Notice 97-21, Z’s interest expense attributable to the fast-pay arrangement for periods before January 1, 2000, equals the interest accrued on the debt instrument held by the fast-pay shareholders, plus the interest accrued on the debt instrument held by the benefited shareholders other than Z. For purposes of paragraph (g)(2)(i)(A) of this section, Z’s interest expense is as follows:

2000–4 I.R.B. 385 January 24, 2000

Accrued Accrued Interest Interest Total Fast-pay Other Benefited Interest Taxable Period Shareholders Shareholders Expense 1/1/97 - 12/31/97 ($ 8,574) ($1,861) ($10,435) 1/1/98 - 12/31/98 ($ 7,852) ($2,015) ($ 9,867) 1/1/99 - 12/31/99 ($ 7,067) ($2,184) ($ 9,251) ($23,493) ($6,060) ($29,553)

(iii) Recharacterization under this section . Under paragraphs (c) and (g)(2)(i)(B) of this section, Z’s taxable income attributable to the fast-pay arrangement for periods before January 1, 2000,

equals Z’s share of the dividends actually and deemed paid on the benefited stock (80 percent of the outstanding benefited stock), reduced by the sum of the interest accrued on the note held by Y and the

interest accrued on the financing instruments deemed to have been issued by Z. For purposes of paragraph (g)(2)(i)(B) of this section, Z’s taxable income is as follows:

Accrued Accrued Dividends Interest Interest Benefited On Debt Financing Taxable Taxable Period Stock Held By Y Instruments Expense 1/1/97 - 12/31/97 $14,400 ($18,000) ($ 6,859) ($10,459) 1/1/98 - 12/31/98 $14,400 ($18,000) ($ 6,281) ($ 9,881) 1/1/99 - 12/31/99 $14,400 ($18,000) ($ 5,654) ($ 9,254) $43,200 ($54,000) ($18,794) ($29,594)

§602.101 OMB Control numbers .

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(b) * * *

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

Approved January 7, 2000.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 7, 2000, 8:45 a.m., and published in the issue of the Federal Register for January 10, 2000, 65 F.R. 1310)

(iv) Limit on taxable income under this paragraph (g)(2) . For periods before January 1, 2000, Z has a taxable loss attributable to the fast-pay arrangement of $29,553 under the recharacterization of Notice 97-21 and paragraph (g)(2)(i)(A) of this section, and a taxable loss of $29,594 under the recharacterization of paragraphs (c) and (g)(2)(i)(B) of this section. Thus, under paragraph (g)(2)(i) of this section, Z may report a taxable loss attributable to the fast-pay arrangement for periods before January 1, 2000, of either $29,553 or $29,594. Under paragraph (g)(2)(ii), Z has no adjustment to its taxable income for its taxable year that includes January 1, 2000.

(3) Rule to comply with this section . To comply with this section for each taxable year in which it failed to do so, a taxpayer should file an amended return. For taxable years ending before January 10, 2000, a taxpayer that has complied with Notice 97–21, 1997–1 C.B. 407 (see §601.601(d)(2) of this chapter), for all

such taxable years is considered to have complied with this section and limited its taxable income under paragraph (g)(2)(i)(A) of this section.

(4) Reporting requirements . The reporting requirements of paragraph (f) of this section apply to taxable years (of the person required to file the statement) ending after January 10, 2000.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 5. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 6. Section 602.101(b) is amended by adding an entry in numerical order to the table to read as follows:

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

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49.4251–4(d)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1628

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January 24, 2000 386 2000–4 I.R.B.